A Real Options Approach to Multi-Year Contracts in Professional Sports

This study utilized a number of useful innovations to estimate marginal revenue product’s for Major League Baseball free agents.Two robust results emerged from our empirical results. Free agents that are paid a salary below the MLB average tend to be underpaid, while those paid a salary above the MLB average tend to be overpaid. In addition, free agents on single-year contracts tend to be underpaid, while those on multi-year contracts tend to be overpaid. These results are not consistent with the standard monopsony talent market assumption, unless one resorts to arguing that the talent market is segmented. We develop a simple model of real options to demonstrate how a player can be overpaid or underpaid depending upon the length of the contract, the available opportunities for the player to move during the contract period and the player’s expected performance. We believe that a real options approach to player contracting is an important addition to the market-based approaches relied upon in the past.