Munich Personal RePEc Archive A Real Options Approach to Multi-Year Contracts in Professional Sports Rockerbie, Duane and Easton, Stephen University of Lethbridge, Simon Fraser University 30 March 2019 Online at https://mpra.ub.uni-muenchen.de/93062/ MPRA Paper No. 93062, posted 02 Apr 2019 13:15 UTC 1 A Real Options Approach to Multi-Year Contracts in Professional Sports Duane W. Rockerbiea Stephen T. Eastonb March 2019 aDepartment of Economics, University of Lethbridge, 4401 University Drive, Lethbridge, Alberta, Canada, T1K 3M4. E-mail:
[email protected] bDepartment of Economics, Simon Fraser University, 8888 University Drive, Burnaby, B.C., Canada V5A 1S6. E-mail:
[email protected] JEL codes: L83, J24, Z22 Keywords: marginal revenue product, free agents, put options, baseball 2 “It isn’t really the stars that are expensive. It is the high cost of mediocrity.” Bill Veeck, owner at various times of the Cleveland Indians, St. Louis Browns and Chicago White Sox. 1. INTRODUCTION The standard approach to explaining the rigidity of long-term labor contracts employs a risk- neutral employer offering such a contract to risk-averse workers who value stability in their wages. Early contributors were Baily (1974) and Azariadis (1975). Rudanko (2009) is a recent example. Labor productivity generally behaves pro-cyclically (Romer, 2012), consequently workers experience periods where their marginal revenue product (MRP) can fall above or below a normally contracted wage. Employers will then display pro-cyclical employment. Risk-averse workers will accept a long-term contract with employment stability in exchange for a wage below their MRP and risk-neutral employers are happy to agree to such contracts.