Opportunity Cost and Sports Contracts
Nassim Taleb writes in The Black Swan, “We see the obvious and visible consequences, not the invisible and less obvious ones. Yet those unseen consequences can be--nay, generally are--more meaningful...Recall the confirmation fallacy: governments are great at telling you what they did, but not what they did not do.”
Opportunity cost is the number one tool in analyzing the financial side of professional sports. It’s also the process of examining the second order effects of capital allocation.
We’ll define opportunity cost as “the forgone benefit that would have been derived by an option not chosen.”
Take the salary cap for example. There are structural differences across the leagues that change the opportunity cost of every dollar spent. Let’s compare the NFL, NBA, and MLB.
The NFL has a hard cap where every team can only spend X amount of dollars on players every season. There is a little fluctuation across teams because you can carry over unused cap space each season.
The NBA has a soft cap where if teams go over the cap they have to pay an exorbitant amount in taxes.
The MLB has a luxury tax threshold where if teams cross that amount they have to pay taxes.
Every transaction has the first order effects of dollars paid/received, and the second order effects of opportunity cost. I want to take a closer look at two recent transactions: (1) Trevor Bauer signing with the Dodgers and (2) Patrick Mahomes’ new contract with the Chiefs.
On the surface, Bauer signed for 3 years, $102m with the Dodgers. There are two important details that are missing. First, the yearly payouts are $40m in year one, $45m in year two, and $17m in year three. Second, Bauer has a player option after each season. This means he can choose whether to stick around for each of the next two seasons or become a free agent again. As you already figured out, there’s no way he plays that third season for $17m. It’s purely window dressing.
From Bauer’s perspective, he’s able to enter free agency again whenever he chooses. He rightly knows that player salaries are not determined by “fundamentals” but by market forces. If he plays well this year and there are few pitchers available in free agency next year, maybe he opts out and commands more than $45m.
I can’t imagine a better foregone option. I doubt anyone was willing to pay him $85m over two years with a player option.
How about from the Dodgers perspective? This is more interesting. What is the opportunity cost of the $40m spent on Bauer this season? Remember, the penalties imposed by overspending in the MLB are not nearly as harsh as the NBA.
The Dodgers are also a big market team. For that reason alone, the Dodgers opportunity cost of $1 is lower than that for a small market team, especially when it comes to signing longer term deals. Let’s say Bauer has a terrible season and then decides to exercise his player option for 2022 and stick around for $45m. For reference, $45m is currently more than the entire payroll for 3 teams this season (Orioles, Pirates, Indians).
One of those teams pays a player that much money who doesn’t perform and the franchise is set back for years. A capital heavy team like the Dodgers or Yankees can eat those contracts and simply move on to the next one. That’s the entire premise of Moneyball. Teams are constantly working to lower their opportunity costs. Out of necessity, small market teams have to gain an informational edge to more productively spend their next $1.
Now for Patrick Mahomes. At first glance his 10 year, $450m contract extension looks like it pays him about $45m per year but that’s not the case. Across the first three seasons (2020-2022) he’s earning just over $63m. Comparably, Deshaun Watson signed a 4 year extension that pays him $74.8m over the same three seasons.
Mahomes undoubtedly could have commanded more money at the onset of the deal. Same goes for Travis Kelce. Instead, he agreed to a back-loaded deal that might be outpaced by several other quarterbacks in the future. It’s possible that Mahomes is never the highest paid quarterback in a single season. I know what you’re thinking, “but he has the security of making all this money.”
To gauge the opportunity cost of this deal we have to look at all possible alternatives. Usually, the benefit of a long term deal is guaranteed money upfront as a hedge against injury risk. That doesn’t apply to quarterbacks. As we’ve seen with Alex Smith, there are few injuries that will now end a career. Even with Dak Prescott, he has not lost an ounce of leverage in negotiations with the Cowboys.
Of all possible scenarios to play out in the future, there are many where Mahomes would have earned more money.
On the other hand, the Chiefs must be thrilled. This is why GM Brett Veach was lauded last offseason for being up against the salary cap and still managing to keep their core of Mahomes, Kelce, Clark, and Jones intact. Mahomes and Kelce agreed to incredibly team-friendly deals.
There weren’t many better alternatives for the Chiefs.
Recall Taleb’s quote about governments not being great at telling you what they didn’t do. We have to judge each transaction from the viewpoint of the transaction itself (first-order) and the possible alternatives (second-order). Only then can we determine the opportunity cost for everyone involved, or not involved.