The Reserve Clause and the Failure of the Free Market

‘”The salaries base ball players want nowadays,” said a prominent manager the other day, “are simply preposterous. It’s an outrage, the prices we have to pay for talent.” This is all very well from the managers’ standpoint. If the players had anything to say on the subject, he would be equally justified in remarking: “I know my salary is a big one, but So-and-So makes big money and can afford to pay it. He only engages me because he wants me. If he couldn’t make money off of me he wouldn’t engage me, and if I could make him pay me a hundred a week more I’d do it.” The relations of managers and player are admirably regulated under the laws of demand and supply. In an era of large returns large expenditures are the just rule. The man whose profits are handsome can afford to pay those who help him earn them handsomely, and he ought to do it. It is the fault of those whom he has to pay if he does not pay enough, and it is as unjust of him to blame his employee for setting a high price upon himself as it would be in the employee to blame him for taking in all the money he could at the gate. When the profits of the business decline, salaries will go down of their own accord. As long as there is enough amusement money afloat to keep the base ball field as full of attractions as it is, good players will be scare and dear. For the sake of all hands we trust they will be scare and dear for many years to come.’ Source: The Sporting Life July 15, 1883

The argument quoted here is commonly heard to this day. It is dead wrong, in both obvious and non-obvious ways. The writer probably was Francis Richter, the editor of The Sporting Life and a major figure in baseball journalism well into the 20^th century.

Richter was a fine sports writer. There was a fashion for baseball histories in the 1910s. His History and Records of Baseball from 1914 is the best of the lot. Richter was not, however, competent in economics. This leads to the obvious problem with his analysis. He confuses supply and demand with the idea that a more profitable business pays, or ought to pay, its employees more than a less profitable business. The argument that it does is only indirectly connected with supply and demand, and the argument that it ought to is a moral rather than an economic argument.

This is largely uninteresting: an Econ 101 mistake. My topic here is the more interesting, and controversial, underlying fallacy: that the free market principle of supply and demand can possibly work in a professional team sport.

First a review of the basics. How is price of a widget determined? The supply-and-demand side is simply that higher supply and/or lower demand will lower the price, while lower supply and/or higher demand will raise it. Next we look at each side. On the supply side, if the price of a widget is so low that a widget manufacturer cannot make a profit, some manufacturers will drop out of the business, thereby lowering the supply, until the price rises to a profitable level. Or, if the price of the widget is so high that manufacturers enjoy a windfall, widget production will be increased and the price will come down. On the demand side, if the price is high then some widget users will find an alternative to widgets or simply do without, lowering the demand and therefore the price. If the price is low, then they will buy more, increasing demand and raising the price. These natural adjustments are Adam Smith’s “invisible hand.” This is much over-simplified, of course, but it is an elegant system, and often even works, albeit more messily, in real life.

Now let’s apply this to labor. Suppose you wanted to put a bathroom in your basement, and had the good sense not to try to do the plumbing yourself. How do you choose a plumber? Maybe you know a guy, and go with him, but for our hypothetical let’s suppose you don’t. The important criteria are (1) can he do the job right (as contrasted with the innumerable wrong ways it could be done) and (2) price. So you do your research (ask for recommendations, check Angie’s list, etc.) to compile a list of guys who can do the job right, and then call around for prices. The invisible hand does its magic: if your area is over-supplied with plumbers this will drive their prices down, and some will leave; if under-supplied, their prices will go up until more plumbers are attracted to set up shop. If there is a lot of construction going on, the price for a plumber will go up and you might decide to wait on the basement job. When the construction market tanks, that will be a good time to hire a plumber cheaply.

This doesn’t work in professional team sports. There are two reasons: owner incentives are complicated and inconsistent; and that labor market model using plumbers contains simplifying assumptions that are invalid for professionals sports.

What is the owner of a team trying to accomplish? Roughly speaking, there are two goals: to make money and to win championships. At first glance, these goals complement one another. A winning team will attract more fans, and therefore bring in more revenue, which can be used to hire even better p layers. This is true so far as it goes, but revenue and profit are different things.

Under some circumstances, an owner who cares only about profit and is indifferent to winning can do better fielding a horrible team than a good one. Good players can be sold for cash, bringing immediate revenue. Most leagues have at least partial revenue sharing (e.g. splitting gate receipts between the visiting and the home clubs), ensuring a baseline of revenue no matter how bad the team is. Reduce your expenditures below that baseline, and you have guaranteed profits. This is why in 1915 the Athletics went from perennial powerhouse to perennial cellar dweller. Connie Mack switched business models. Then in 1977 the Athletics did the same thing again, this time with Charlie Finley the culprit. The most egregious example comes from football, where the pre-Carson Palmer Cincinnati Bengals suckered the city into a truly astonishingly bad (or good, depending on your perspective) contract, with the city guaranteeing ticket sales. The ownership at that point responded rationally to the incentives, and maximized profits by not wasting money on such frivolities as fielding a competitive team.

More common is the owner who cares about championships more than profits. For all that baseball has been culturally prominent since before the Civil War, as a business it has always been relatively small time. Thus the potential for the rich owner who regards the team as a hobby. Making money simply isn’t the point. This phenomenon goes as far back as 1884, when St. Louis millionaire Henry Lucas was so eager to own a pennant-winning major league club that, upon finding himself excluded from the existing leagues, he founded and bankrolled a league his own. (OK, that is an oversimplification of the Union Association. There was more going on than just Lucas buying a vanity project. But that was a big part of what happened.)

Owners who can take the team payroll out of their petty cash box is the extreme case. More typical are owners who want both to win and to turn a profit, with varying levels of optimism, caution, and common sense.

Next we come to the simplifying assumption in the plumber scenario. When you are looking for a plumber, the candidates fall into two categories: guys who you are reasonably confident will do the job right, and guys you aren’t confident will do the job right. Within the first category, it isn’t really meaningful to rank which plumber is better. What does that even mean? A more esthetically pleasing pipe joint? Perhaps it would mean a more durable joint, but how would you know, and is this likely to be an issue within the time span you care about? In practice, everyone within the group is pretty much interchangeable, so you make your selection based on other factors such as price and availability.

This is far from the case with athletes. There are, at any given time, thirty major league starting shortstops (to arbitrarily pick a position). No one would consider the best starting shortstop in MLB and the worst to be interchangeable. The best is far more valuable. Baseball has since the Civil War used statistical analysis to measure playing ability. While earlier statistics seem primitive in light of modern sabermetrics, they were persuasive at the time. At any time, there was a very small number of guys who could plausibly claim to be the best shortstop anywhere, and could market their services accordingly. Even a financially sensible owner might see his rival sign the best shortstop, and conclude that he had better go out and get the best second baseman.

Put in terms of supply and demand, the demand always outstrips the supply. A few clubs don’t care about winning, and are content with signing a minimally competent shortstop as cheaply as possible. Most clubs want the best shortstop they can get, and a few of these clubs are willing to spend with wild abandon to accomplish this. On the supply side, plenty of guys are minimally competent, so they can be had cheaply. But the supply of the best shortstops is tiny: as small as one. Thus in an unregulated free market governed only by supply and demand, the price of top talent will always rise. The price of second-tier talent will follow, and third-tier behind that. The only mechanism to halt the constant inflation is club bankruptcy and the entire system collapsing.

Enter the reserve clause, which was destined to be baseball’s chief mechanism for suppressing player salaries. This is the subtext to Richter’s editorial. The reserve system had been instituted after the 1879 season, as the “five-men rule” with each club reserving five players. The discussion in 1883 was its expansion to eleven players.

1879. This is significant. This was the depth of the depression following the Panic of 1873. Professional baseball had been under financial stress since 1875. By 1879 it was in severe decline. The nadir would be 1880, bottoming out at only ten fully professional clubs in the nation. (By way of comparison, in 1877 there had been between forty and fifty.)

If player salaries were regulated by supply and demand, they would have been dropping to new lows in 1879. There was a glut of professional ballplayers desperate to be signed. Things were so bad that many had to resort to honest work instead, not that there was much of that available. Yet at the same time, club salaries kept rising. At a special meeting of the National League held August 9, 1878, “the most important question discussed was the salaries of players for next year. It called forth five hours’ discussion, but was finally dropped, no action being taken.” All that came out of those five hours as that “the league declines to continue business on the same basis as this season, and announces to players that in 1879 the aggregate salaries paid by each club must not exceed the sum which the experience of this year indicated that each club would be likely to earn.” (Source: New York Tribune August 13, 1878) In other words, nothing but vague intentions. All those unemployed ballplayers didn’t result in lower salaries because they weren’t the talent pool the National League was recruiting from. The League hired the best players, at least as a first approximation, and League clubs competed against one another for those players.

The next year some evil genius figured it out: “At the recent meeting of the League it was agreed, for the sake of securing good players at small salaries, that five men in each nine should not be negotiated with by other League teams.” (Source: New York Clipper October 25, 1879)

There are two strategies that have been successfully employed by sports leagues to keep salaries down: a reserve system, and a salary cap. The salary cap is the more intuitive, but it can be difficult to implement. Individual clubs have a strong incentive to cheat: to find some surreptitious way to sweeten the offer to a top player. 19^th century attempts at imposing salary caps tended to be dead letters from the start. Salary caps work today in major sports leagues because the dollar amounts are too large to slip under the table. You can’t put ten million dollars in an unmarked envelope and pass it when no one is looking. Any serious attempt at cheating at today’s numbers would amount to a money laundering racket, which could result in unwelcome attention. But under 19^th century conditions a salary cap was unenforceable.

The reserve system works because there is no way to cheat surreptitiously. Any cheating will be out in the open. The way it initially worked was that the National League clubs made a gentlemen’s agreement. Each could designate five players they wanted to keep for the following year, and the other clubs agreed not to sign any of those five. This was expanded a few years later to eleven per team. Clubs typically carried around thirteen or fourteen players total, so in reality at eleven men all but the marginal players were reserved.

How is this legal, you ask? Isn’t this a conspiracy in restraint of trade? Of course it is. And while this was before the Sherman Antitrust Act, there was an ample body of common law on the subject. The startling fact is that Organized Baseball is built atop a foundation of unenforceable contracts, extortion, and what in other contexts would be criminal conspiracy. Why this came about and how it was sustained is a topic for another day. In the meantime, you have to just go with it, and not assume that legal norms apply.

They reserve system was durable. It expanded to accommodate the growth of baseball into a hierarchy of leagues, forced to cooperate, however grudgingly. It survived intact for nearly a century. Not until 1975 was it significantly modified, after Major League Baseball in a moment of inattention agreed to collective bargaining and arbitration, without quite thinking it through.

Notice that I wrote that the reserve system was “modified.” The usual narrative is that the reserve system was abolished, bringing on the free agency era. The usual narrative is bollocks. The reserve system remains integral to organized baseball. The modification is that a player’s reserved status is no longer perpetual. In the old version, a player was locked in from the day he signed his first contract to the day he retired. In the modified version he is reserved for a set number of years, after which he becomes a free agent. If, in the old version, the player was a well-paid slave, in the new version he is a well-paid indentured servant.

Organized baseball could not function without the reserve, or something like it. Even as the Yankees and the Dodgers spend like sailors on shore leave, other clubs can build on a core of younger players still under reserve. Yes, you can buy your way into the playoffs, but that is not the only way to get there. This prevents the system from entering into an inflationary death spiral.

So it is that I am reluctantly forced to concede that the owners have a point. The free market, contra Francis Richter, isn’t up to the task.