February 22, 2010

No Pepper

Search Costs Versus Surplus

by Tommy Bennett

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Last week, Buster Olney reported that Russell Branyan had been signed by the Cleveland Indians to a one-year, $2-million deal that included up to $1 million in incentives and a $5-million mutual option for 2011. Two weeks ago, the Mariners signed Erik Bedard to a similar deal (one year, $1.5 million plus incentives with an $8-million mutual option for 2011). Over the years, many have wondered about the usefulness of mutual options. What are mutual options, and why would teams and players agree to them?

There are three ways an option can be structured: player, team, or mutual. Player options must be exercised by the player to take effect; team options must be exercised by the team. (For the interesting result that team options at the end of long-term contracts are exercised unpredictably, see Dinerstein 2007 (PDF)). Mutual options, however, must be exercised by both the player and the team to take effect.

One common view is that mutual options are essentially meaningless. Last year, Craig Calcaterra wrote of Ned Colletti's mutual option for 2010:

[I]sn't it just as accurate to say that you or I have a mutual option to be the GM of the Dodgers next year? The Dodgers have to agree to hire us, you or I have to agree to take the job. Isn't that the basis of almost everyone's employment?

Accord that sentiment with Rany Jazayerli on the topic of Scott Podsednik:

This "mutual option" thing seems to be an idiosyncrasy of the Moore administration; I don't mind them, but it does make the contracts a little confusing to the outsider. Based on what we know about Miguel Olivo's contract, a mutual option means that either side can walk away from it, and given that by definition, any contract is likely to be unfavorable to one side or another, a mutual option is basically the same as no contract at all.

I've got a different theory of the mutual option. Let's start with the assumption that looking for a new contract is not costless; rather, it involves costs both material (flying around to talk with different teams) and otherwise (psychic costs of uncertainty, toll on family). The same holds from the team side of the equation. Sticking with the player side for a moment, the economic value of a contract is the amount of money he earns minus the amount of money he could have earned at his next best deal (importantly, this could be negative). But we can't just stop there! We also have to subtract the search costs of finding that new deal. That means that if the search costs (psychic and real) exceed the economic value of the new contract, the mutual option makes sense even for the party in the less favorable position. In this way, teams and players can reduce their transaction costs in the future by providing a default position that is easy to exercise.

But it actually gets even better than that. By including the mutual options, teams and players can demonstrate their intention to continue to work together in the future. This might sound sentimental, but to the degree this effect exists, it's almost completely costless. So the better question to ask might be, "why aren't there more mutual options?" During the offseason, the Astros and Brian Moehler exercised their mutual option. Prior to last season, the Royals and Olivo exercised their mutual option. (At this point, it might be useful to distinguish the wisdom of the option from the wisdom of exercising it.)