Economic Principles Guide Free Agent Market

Vince Gennaro has written another great article, this time explaining the economics behind free agency and different MLB teams’ ability and willingness to pay top dollar for talent. I have linked to two previous entries by Vince Gennaro, so if you have some spare time on your hands, read the entry about A-Rod’s ten year contract and the economics of making the World Series. Gennaro’s latest article, published at Yahoo! Sports, is very interesting as well. One key point raised in the article is the fact that NL and AL teams have different probability distribution curves of making the playoffs, and thus the contracts used to attract free agents in NL vs. AL teams are disproportionate; a 90-win season in the AL translates to around 30% of making the postseason, while a 90-win season in the NL translates to around 65% chance of making the postseason. Gennaro concludes that “free agency isn’t hard science. It’s not abstract art, either. It’s the melding of baseball-operations and financial departments and the decision of where the two intersect.” Read the article, presented in full-text, below.

Economic Principles Guide Free-Agent Contracts by Vince Gennaro

Signing Alex Rodriguez meant more to the New York Yankees than it would have the Kansas City Royals.

Well, yeah. And?

And it makes sense for reasons that go far beyond the obvious, reasons that drive Major League Baseball’s free-agent market and often assign to it sound logic.

Right. Free agency and logic. Aren’t the two mutually exclusive?

They’re not supposed to be, even after the Chan Ho Parks and Darren Dreiforts of the world. In actuality, the savviest teams assign value to a free agent based on two criteria: his future on-field performance and the translation of that performance into financial impact on the franchise. With so much of that dependent on a team’s ability to contend for the playoffs, the urge to overspend in free agency increases, causing a dozen or more teams to fawn over top players, which fuels the feeding frenzies and warps the sense of proper valuation.

What makes sense to one team might not to another, and the key factor is the number of wins a new player is projected to add.

Assessing future performance is an inexact science, one that each franchise does differently with a mixture of scouting and statistics-based analysis. Who has lost a few miles per hour off his fastball? Whose swing looks slower? Who is an injury risk, particularly with guaranteed contracts and huge premiums to insure them? Since free agents are often veterans, many past their peak, estimating the rate of attrition is integral. A 31-year-old who may add six wins to a team today could be worth only two wins in four years.

Though perhaps those six wins early on justify the contract, because they can make the difference between a good team and a great one. Adding a six-win player – each win is determined not by single-game performance but a player’s overall impact throughout a season – is worth far more to an 86-win team than to a 76-win team. The payoff for getting to 92 wins is a possible playoff berth and the financial spoils that accompany it, while an 82-win team does little more than put a few more people in the stands.

Consequently, the typical bidders for high-impact free agents are on the cusp of contention and need that extra boost or want to maintain their playoff status. Both Los Angeles teams fit that bill this offseason, the Angels signing Torii Hunter to stay ahead in the American League West and the Dodgers bringing on Andruw Jones to keep themselves relevant in the National League West. When a team stands to gain a potential $30 or $40 million windfall by reaching the postseason, it’s no surprise they would spend aggressively.

A team’s competitiveness is only one translation of performance into dollars. The size of the market, the player’s position, the length of contracts and the pursuit from a division rival matter too, all of them working into a team’s win-curve.

In my book, “Diamond Dollars: The Economics of Winning in Baseball,” I wrote about the concept of the win-curve – my attempt at estimating the change in a team’s revenues that correspond to each win total – derived using statistical tools, such as regression analysis, on a team’s attendance and financial data. Over the last several years, the dominance of the AL over the NL, along with the distribution of wins within each league, has had an impact on the number of wins necessary to reach the postseason and, hence, free-agent values. In each of the last three seasons, an 82-, 83- and 85-win team made the NL playoffs, while in the AL, 90-, 91- and 93-win teams fell short. Using statistical techniques and recent history, we can estimate the probability of reaching the postseason in each league, which is shown in Figure 1. In the AL, a 92-win season yields a probability of 53 percent, while the same win total in the NL translates into a 79 percent chance of playing October baseball.

Figure 1.

This [distribution] has implications both for who bids and how much is bid in the free-agent market. In the AL, it usually means that only 86-plus-win teams can justify competing for the priciest free agents, while in the NL, an 83- or 84-win team can often validate jumping into the fray. The highest-value wins in the AL – the wins that are likely to bring the most incremental revenue – are 88 through 95, while the NL range is three or four wins lower.

Granted, this only matters when teams are realistic about their win projections. Two years ago, Blue Jays GM J.P. Ricciardi, empowered with an influx of cash, signed starter A.J. Burnett and closer B.J. Ryan to five-year contracts totaling $102 million. This would have made financial sense had it truly vaulted the Blue Jays into contention – were they, say, an 86-win team before they added the pair. In 2006, Toronto finished with only 87 wins, falling far short in the highly competitive AL wild-card race. Last season, Ryan blew out his elbow and missed the whole season, and Burnett missed nine starts because of injury.

It’s essential for teams to understand the sweet spot of the win-curve. Although it’s difficult to criticize a team for trying to improve through free agency, franchises must understand the size of their market and how they stand to gain financially. The win-curve is a team’s DNA, unique and vital, and in many cases it leads to radically different valuing of a player.

Figure 2 shows my estimates of the win-curves of the Yankees and the Royals. A free-agent signing who improves the Yankees from 89 to 94 wins is worth an estimated $20 million, while the same hypothetical improvement in Kansas City is valued at about $13 million. In reality, the dollars are not even that close because the Royals generally operate on the flat part of the win-curve – near the 70-win portion – where adding a few wins hardly moves the revenue needle.


Figure 2.

 

Take the Royals’ signing of Gil Meche in 2006 for $55 million over five seasons and Jose Guillen this year to a three-year, $36 million deal. The Royals are trying to assert themselves with a foray into the free-agent market, confident that the arrival of Billy Butler, Alex Gordon, Zack Greinke, Joakim Soria and other young players is enough to supplement the expensive talent. If not, Kansas City will have handicapped itself, as the revenues will not grow nearly enough to support a payroll bogged down by the fat checks. Low-revenue franchises cannot afford mistakes, particularly in free agency, and are better-served developing cheap talent internally through superior scouting and development, jumping toward the higher end of the win-curve and then diving into the free agent market for the last couple of pieces of the puzzle.

Kansas City did sign a No. 1 starter (Meche) and power-hitting corner outfielder (Guillen), the latest proof that a team will overpay to fill specific needs. Free-agent shortstops have been unlucky in recent years as the Yankees and New York Mets – teams with steep win-curves – have not been in the bidding because Derek Jeter and Jose Reyes have been mainstays. Designated hitters are appropriately penalized by having less than half the teams in the mix for their services, as any GM will tell you that David Ortiz and Travis Hafner are AL-only players.

The opposite is true with pitching. With room for five starting pitchers on every staff, the primary difference between an ace and No. 5 starter is quality. Even a middle-of-the-rotation free-agent starter can be considered a replacement for a team’s fifth starter, creating bidding wars among the teams with the strongest win-curves – those with the most to gain financially – and leading to the current market for pitchers.

To date, 12 of the top 15 free agent relievers on Yahoo! Sports’ free-agent rankings have signed with 10 different teams – and only Matt Herges for less than $3 million a year. Relief pitchers’ role in critical late-inning situations has caused their value to spike far beyond what seems appropriate for those who pitch only 60 or 70 innings.

When the Diamondbacks can compensate for an NL-low batting average of .250 by riding a stellar bullpen to the NLCS, teams recognize that relief pitching can be a quick fix to get them to October, as in $19 million worth of quickness in the case of Scott Linebrink and the Chicago White Sox.

Some teams are better at evaluating talent and prospective free agents’ expected performance, while other teams have better insights into the relationship between their on-field performance and revenues. Teams generally fall short in properly valuing contract length, as bad deals handcuff teams with burdensome salaries long after a player’s contribution has deteriorated. One example: Jason Giambi’s seven-year, $120 million deal with the Yankees, set to expire after the 2008 season. In hindsight, the Yankees might have wished they paid $100 million for a five-year deal – $3 million average annual value – but $20 million less in total cost, allowing them to cut off Giambi before his 36th birthday.

Intradivisional competition is a somewhat subtler and less-talked-about component of a free agent’s value. Johnny Damon hit the free-agent market two years ago. The Yankees needed a center fielder and felt Damon could supplant Bernie Williams and add to their win total. The hidden value in this signing – at the time, at least – came from stealing Damon from their archrival and chief competition for the AL East crown, the Boston Red Sox, whose center-field play from Coco Crisp proved inferior to Damon’s.

Snagging Damon had the double effect of helping the Yankees and hurting the Red Sox, and since the postseason comes with its pot of gold, it enhanced Damon’s dollar value.

For a year. Damon aged rapidly, moved to left field and, with half of his four-year, $52 million contract remaining, could go down as another free-agent blunder by the Yankees.

Remember, free agency isn’t hard science. It’s not abstract art, either. It’s the melding of baseball-operations and financial departments and the decision of where the two intersect. Sometimes it even makes sense.

Sometimes.

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~ by mlb2007playoffs on December 11, 2007.

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