December 28, 2015

Tools of Ignorance

Behavioral Economics and the Rise of the Player Opt-Out

by Jeff Quinton

“The logic of the opt-out clauses for the club escapes me.” —Commissioner Rob Manfred

Nothing gets the baseball internet writer hot like a newly popularized contract structure. Rob Neyer has weighed in on the potential benefit to team of a player opt-out, and Dave Cameron* has weighed in on how these cannot be seen as anything but additional costs. Neyer’s point is that giving a player an opt-out is often preferable to giving a player more money. Cameron’s point is that giving a player an opt-out is less preferable than not giving a player an opt-out. Both points are correct. Like most things, if we change the perspective, then we can look at anything as a positive or a negative. More simply, everything is better than a worse scenario and everything is worse than a better scenario.

So why the need for another article? Because unaddressed remains the most curious question about the player option: Why has it become so popular? Put differently, what benefit does the structure provide for each side as an alternative (in most mega-deals) to just agreeing on more money? We will take a look at what is in it for both parties and see what we can find.

Going back to Neyer’s assertion—that teams prefer giving such an option to giving more money—well, that comes with a big ol’ “it depends.” My guess is that teams perform some sort of analysis and put a value on offering a player option for each year of the contract (something similar to what was done by Eno Sarris, probably including the frictional costs mentioned by FanGraphs commenter Josh), and then negotiate with that cost in mind. For example, if a team values an opt-out for a specific player at year three of a six-year contract at $12 million, they would be indifferent to the choice between a six-year, $132 million contract with no opt-out and a six-year, $120 million contract with a player opt-out after year three. All this is to say that teams would prefer giving a player option to giving more money to a point.

So, either contracts with player options are falling more and more on the “more favorable than paying more” side of this cost-benefit analysis, or players value the opt-out more than teams do. First, we'll take a look at this from the players’ perspective.

Optimism
People are particularly optimistic about their futures. (This is known as the Optimism Bias.) We imagine that the future will not hold unforeseen negative events, particularly if the recent past did not hold those events. We think things will generally work out. Then the company we work for, which has never had layoffs, has layoffs. Then our town, which has only seen property values rise for a half-century or more, sees a downturn in property values. We are generally ill-prepared for these bummers because we never saw them coming.

Additionally, we imagine the best from ourselves. We are going to exercise more, eat healthier, be better listeners, be more available friends and partners, wake up earlier, get more sleep, save more money, spend more time doing what we love, bring lunch more, eat out less, clip our big-toenails more frequently, floss, save more money, withdraw less cash from out of network ATMs, etc. Then the alarm goes off and we hit snooze. Then we walk into work and Sharon from operations finance brings in those unbelievably delicious Danishes from the bakery by wherever she lives and we eat 75 percent of our daily calories before lunch starts.

Combine these ways that we are overly optimistic about the future, and it becomes unsurprising when when a 29-year-old baseball player agrees to sign for $15 million less in order to potentially cash in on another payday at age 32. If he continues to perform as forecasted and if money continues to flow into the game, then his $15 million will most likely pay off fivefold, and we love betting on ourselves. One only needs to look at the divorce rate, or the failure rate for startups. Additionally, the more successful we are (such as being good enough at baseball to be the recipient of $100 million-plus contract) the more ammunition our brains have to convince ourselves that the future holds less risk than it really does.

Intertemporal Choice
George Loewenstein and Richard H. Thaler published “Anomalies: Intertemporal Choice” in The Journal of Economic Perspectives in 1989. As a definition for intertemporal choice, these two use “decisions in which the timing of costs and benefits are spread out over time.” In this article, the authors examine “a number of situations in which people do not appear to discount money flows at the market rate of interest or any other single discount rate.” This is particularly interesting because it might explain why we are seeing opt-outs more frequently with huge contracts than we are with smaller contracts. The article refers to this as “magnitude effects,” and explains,

“People are sensitive not only to relative differences in money amounts, but also to absolute differences (Loewenstein and Prelec, 1989b). The perceptual difference between $100 now and $150 in a year, for example, appears greater than the difference between $10 now and $15 in one year, so that many people are willing to wait for the extra $50 in the first instance, but not for $5 in the second.”

By this logic, players might want to take more money and pass on the opt-out for smaller contracts (instead of potentially deferring a couple million dollars), while preferring to take less money with the opt-out for larger contracts (as to not potentially defer tens of millions of dollars or more).

Mental Accounting
A quote from behavioral economics that we have previously used: “People spontaneously generate their own mental accounts, and where we place these boundaries subtly (but profoundly) influences financial decision making.” Given the amount of money now in the game and now being paid to players, it is not improbable to think that players are now making more than they ever imagined and/or more than they know what to do with. As figurative Joey from Springfield might say, “He already made $110 million. What does the extra $15 million on the next contract matter? I always knew he was me-first guy. No wonder he doesn’t have any rings.” While Joey’s perspective might be entirely derived from his literal rooting interests and thus discredit his analysis, there is something to the idea that at certain thresholds, people might change their valuation mechanisms. In other words, once a certain monetary goal is reached, it is not unreasonable to consider that a player might start to value non-monetary factors more greatly.

Most of us have never been in the position to decide between $170 million over six years and $150 million over six years with opt-outs at years three and five, but we can certainly imagine the benefits (beyond the potential financial upside) that would make the latter more appealing. What if ownership or management changes for the worse? What if I do not love the area and want to play somewhere else? Moreover, if the player values non-monetary factors while the teams only value monetary factors, then this is something we would expect given how negotiation works. Parties generally prefer to concede those things they prioritize lower, in order to get more of what they prioritize highly.

Given the above, there appear to be plenty of reasons why players might be valuing player options more than they did before and more than teams do, particularly for large contracts. Given the influx of money into the game and given the increased sophistication of today’s front offices, these reasons might be all that are needed for an increase in the popularity of player options. There might be, though, reasons that the player option is more of a benefit to the teams as well (which will be covered more briefly).

• Overconfidence and non-monetary factors: We already mentioned optimism on the player side, but much of that was actually overconfidence. Such overconfidence might cause players to opt out below market value (as we saw Kendrys Morales, Stephen Drew and Nelson Cruz do with the qualifying offer two years ago). They might also choose to opt out for the non-monetary factors discussed previously. Neither scenario is likely, but both outcomes have a greater than zero probability and thus carry some value to the team.
• Future markets: The more money that flows into the game, the more costly a player option is to teams because it will cost more to replace the player via free agency. That said, if teams expect free agency inflation to slow, then the value of the player option might be less than we think.
• Insurance: I have no idea how insurance works for teams, but I wonder if teams could get insurance for the instance of a player not opting out. I have no idea if this is possible or financially realistic, but I do imagine that it would be easier to structure this type of insurance if there is an option than if there is not option at all.

Ultimately, the player option, like any other contract structure, has a value (positive or negative) to the player and to the team, just as an extra year or an extra dollar does. Consequently, the rise of the player option is maybe not as unexplainable as Commissioner Manfred thinks. If the assumption is that teams are simply offering $150 million with an opt-out and $150 million without an opt-out, then yes, of course, the opt-out makes no sense. But if we assume that the opt-out comes with less money than would otherwise be offered (and this is a more reasonable assumption), then we cannot know the actual costs of the player options being agreed to in these contracts. Based on the above, though, it appears that the player option might actually be more of boon to teams than we think.

*It should also be noted that Cameron has written pretty exhaustively and excellently about the subject—taking a look at it from multiple angles—looking at many of the different costs and benefits associated with the structure.

Jeff Quinton is an author of Baseball Prospectus. Follow @jjq01
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