This week we offer a brief interlude from the world of healthcare to kick off a new intermittent series: “Business Strategy in Unlikely Places.” On semi-regular basis we will talk about various topics in business strategy, which is the “other half” of our job here at Kellogg.
In addition to being economists and strategy professors, we are both big fans of sports in general and basketball in particular. Therefore, we couldn’t help but notice the recent tiff between Kobe Bryant (one of the best basketball players in the world over the last two decades) and Jurgen Klinsman (the coach of the United States national soccer team).
It all stems back to an interview in the New York Times magazine where Klinsman said many controversial things. First, he admitted that he thought the United States couldn’t win the World Cup this year, which may be accurate (although for a few minutes yesterday we felt irrationally exhuberant about our chances) but was strange to hear from that source. More interestingly, Klinsman said the following in response to people who were critical of him leaving veteran Landon Donovan off of the 2014 World Cup Roster:
“This always happens in America … Kobe Bryant, for example—why does he get a two-year contract extension for $50 million? Because of what he is going to do in the next two years for the Lakers? Of course not. Of course not. He gets it because of what he has done before. It makes no sense. Why do you pay for what has already happened?”
Perhaps unsurprisingly, Bryant was none too pleased about this comment and had the following response to ESPN Magazine:
“I thought it was pretty comical, actually. I see his perspective. But the one perspective that he’s missing from an ownership point of view is that you want to be part of an ownership group that is rewarding its players for what they’ve done, while balancing the team going forward. If you’re another player in the future and you’re looking at the Lakers organization, you want to be a part of an organization that takes care of its players while at the same time, planning for the future.”
While we could write this off to sour grapes from Bryant, in reality he is sketching out an important strategic point. To understand this point requires a bit of context. Under the collective bargaining agreement of the NBA, teams are constrained in how much they can pay in salary each year and the maximum amount that can be paid to any player in a year. As a result, star athletes such as Bryant are likely paid less than their actual value to the team. When Bryant led the Lakers to five titles, he brought in hundreds of millions of dollars in additional revenue for the team owners. But his salary has been capped at a bit over $20 million, and he could not receive more than a token bonus for his superlative effort.
The upshot of this is that, as a result of the salary cap, the Lakers could not pay Kobe Bryant his true value during his prime years. Without getting lost in the intricacies of the salary cap, the same is more or less true for all teams trying to hire superstars. The superstars are always paid less than they are worth and they are paid pretty much the same at each team. How then can the Lakers and other teams compete to land top talent?
Unable to up the ante on salary for current superstars, teams engage in elaborate courtships where they sell other attributes. The Miami Heat offer the twin attractions of South Beach and no state income tax. Los Angeles offers its glamorous life style, Boston has tradition, while New York offers, well, New York. Dranove thinks Chicago has much to attract star athletes, including a strong shot at winning a title (Are you reading this Carmelo? No? Why not?). Garthwaite thinks star free agents should be intrigued by the possibility of bringing the Pistons back to their “Bad Boys” glory.
But what if a team could “promise” a current superstar an increase in salary above the cap? League rules prohibit offering this in writing; even verbally committing to pay more would bring down the long arm of the NBA law. However, a team could credibly commit to pay current superstars more than they are worth after their stars have faded (sorry Kobe, we are talking about you). This circumvents the salary cap and effectively allows teams to pay current superstars what they are worth. The question is how can a team do this? Well at least one way is by demonstrating they have done so in the past. This costly signal helps convince future players that they also could ultimately earn more by signing with this team.
Think about it this way. Kevin Durant, the best young player in the NBA, will become a free agent in 2016, exactly when Bryant’s latest contract will expire. The Lakers would love to land Durant. So would every other team. Durant is worth much more than the maximum allowable salary, so no team can outbid any other in the traditional way, and whichever team lands him will pay him less than he is worth. But the Lakers can “outbid” other teams for Durant’s services by demonstrating that they will eventually pay him more than he is worth. How can they assure Durant that statements about “taking care of him” in the future are not just some elaborate cheap talk? By doing the same thing, right now, for Kobe Bryant.
It may appear to Klinsman that the Lakers are paying Bryant for his “past performance.” In reality, they are simply structuring their compensation differently to avoid regulations. Of course, this is most effective in leagues with strict salary caps – something that is not true for European soccer leagues. In an uncapped league, you can just pay players their market value in the current year.
Economists call these types of arrangements implicit or relational contracts. We happen to know a bit about them because our strategy department here at Kellogg has some of the best people in the world who consider these arrangements (Niko Matouschek, Jin Li, and Michael Powell). In situations where firms cannot explicitly write out all provisions of a wage and bonus structure, these types of contracts can be powerful strategic tools. In the NBA, relational contracts might allow a team to effectively attract players who otherwise would view them as interchangeable with their competitors.