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A Long-Run Analysis of Salary Inflation
Posted By Jesse Wolfersberger On February 2, 2012 @ 2:00 pm In Daily Graphings,Research | 40 Comments
The contracts that baseball players sign are some of the longest contracts in business — not just sports. When handing out nine- or ten-year deals, projecting salary inflation is critical, and yet getting an accurate forecast is nearly impossible.
Prince Fielder and Albert Pujols signed huge deals this offseason, which pays the sluggers into 2020 and 2021, respectively. The rate of salary inflation over the next decade will play a big part in how those contracts work out. The most common assumptions are $5 million per WAR and a 5% inflation rate, which would mean Fielder would have to produce 36.9 WAR over the life of the contract in order for the Tigers to “break even.” The break-even number for Pujols’ back-loaded contract is 37.8 WAR:
|Year||Fielder Money||Pujols Money||$/WAR (5% inflation)||Fielder Break-Even WAR||Pujols Break Even WAR|
If we instead assume inflation slows to 3% per year, those break-even levels change to 39.7 and 41.4. It might not sound like much — 3.7 WAR over ten years in Pujols’ case — but that translates to $18 million of contract value.
Everyone knows that baseball players are well compensated for their skills. The gap between baseball salaries and the rest of us massive, and it’s increasing over time. In 1992, the average MLB salary was 32-times the annual income of an American household. By 2010, baseball salaries were 66-times higher.
Is it possible for this trend to continue? Yes and no.
The difference in salaries between Major-Leaguers and the rest of us will continue to increase, but not at its current rate. In the long run, U.S. households will make about 3% more per year, but baseball salaries will increase at about 4% per year, meaning the gap between the average baseball player and the average American will widen by about 1% per year.
On a couple of occasions, I attempted to create a model which would predict salary inflation in baseball for the upcoming season. Both of those attempts looked at short-term predictions — the expected salary inflation given the current state of baseball revenue and the current economic health of the country.
If we pull back and look at the issue in the long term, the new perspective leads to the new 4% conclusion.
The first step is to trace where the money for players’ salaries comes from:
The above chart does not, under any circumstance, represent every nuance of this very complicated system. However, hopefully it shows the source of most of the money behind teams’ payroll.
Let’s start at the top. Households make money. Part of that money is taxed, some money is saved, and everything else is used for consumption. If you multiply the amount of household consumption by the number of households, you get the total pool of money being spent on goods and services.
Some percentage of that pool is spent directly on purchases from a team. That money is revenue for the team. Most of the total consumption money goes for non-baseball goods and services, but some of that trickles down to baseball as well.
As corporations earn money, they have money to spend on advertising, which is a significant income stream for both individual teams and the MLB as a whole. Advertising dollars are what drive the MLB’s contracts with television networks, and thus revenue which is split between the 30 clubs.
So, teams get money from direct sales, team-specific ads and licensing contracts, and a cut of the MLB pie. Yes, this is an over-simplification, but I am trying to keep it easy.
When teams earn revenue, it gets allocated to various parts of the organization, with a large hunk going to pay for player contracts. When teams have more money to spend on players, the supply of players is (presumably) fixed, and thus $/WAR inflation.
What does all of that mean, and how does that lead to a 4% per year conclusion? Well, the two boxes that start the whole process are always increasing. Household income increases by about 3% per year — which leads to 3% more consumption per household. The U.S. population increases by about 1% per year. Therefore, 1% more people and 3% more money yield a 4.03% increase in the pool of total consumption dollars available. As long as all of channels maintain a constant flow to the proceeding step, on a percentage basis, that 4.03% makes it way all the way to the bottom.
But wait a second, if the above is true, then why have baseball salaries risen by 5% on average, and by double digits in some years? Well, the flow chart assumes that the percentage going from one level to the next remains constant. For example, the percentage of income used for consumption or the percentage of team revenue dedicated to payrolls. If any of those increase, then everything below increases, and the amount of salary inflation increases.
For that reason, this is a long-term analysis. I would not be surprised to see salary inflation continue on its current 5% path for a number of years. Eventually, whatever channel that extra inflation is coming from will have to hit a ceiling. Things like the share of income spent on tickets or the percentage of advertising dollars spend on baseball simply cannot increase without bounds.
Whenever the percentage of cash flow from one step to the next is constant, salary inflation will be driven solely by the increases in nominal income and population, which should yield about 4% market inflation.
As stated earlier, this means the gap between baseball players and average Americans will continue to increase. The reason this exists in baseball (and other sports) is that the number of jobs is a constant. Increasing payroll means either increasing the average wage or hiring new employees, and in baseball there are only 750 major league roster spots, so the average wage has to carry all of the inflation.
When will the short-term become the long-term? One can only speculate, but on a 10-year contract, using the long-term estimate seems like a good educated guess.
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