No No No! It’s Already Priced In!

By James Kwak

That was undoubtedly the response of theoretical law and economics devotees to the premature retirement of Kansas City Royals pitcher Gil Meche a few weeks ago, which we discussed in one of my classes last week. Meche signed a five-year, $55 million, guaranteed contract before the 2007 season, which would have paid him $12 million in 2011 simply for showing up, despite a broken-down shoulder that made him an ineffective pitcher. Yet Meche decided to retire, giving up the $12 million. Meche said this:

“Once I started to realize I wasn’t earning my money, I felt bad. I was making a crazy amount of money for not even pitching. Honestly, I didn’t feel like I deserved it. I didn’t want to have those feelings again.”

One of the topics of the class was non-economic preferences, particularly preferences for fairness, which have been a staple of psychology and behavioral economics over the past decade. Classical theory says that Meche should have kept the $12 million for two reasons. The obvious reason is that $12 million is more than zero, and almost certainly more than the disutility of having to show up to work for another eight months. (Although maybe his marginal utility of money is very low at this point, after four years of his big contract.)

The slightly less obvious reason, which is drilled into law students’ heads in the first semester, is that the risk of career-debilitating injury is already priced into the contract. On this theory, parties are free to bargain for whatever contract terms they wish. In Major League Baseball, the standard for free agent contracts is that they are guaranteed, meaning that they cannot be terminated due to injury (and, I believe, only for cause, where cause includes things like going to jail or getting injured in specifically prohibited activities like dirt-bike racing). So, the argument goes, baseball players chose to bargain for contract guarantees, and in return they are getting less of something else that they want — presumably less money. Put another way, the risk of injury is already priced into the contract. If a player goes through his contract without injury, and remains productive, the team is not going to pay him more money simply because of that. (The player will get more money eventually, either by renegotiating partway through or by getting a bigger contract at the end of the current one, but presumably that’s priced in as well.)

This all may be right. More importantly, it provides a powerful justification for taking the money. It’s hard to stand up and say, “I’m taking the $12 million because it’s in my contract, and I want it, and it’s legally mine.” It’s a lot easier to say, “Teams and players are free to contract however they want, and I accepted less money each year because I got a guarantee, so the $12 million is not only legally but morally mine — it’s just like the payout on an insurance contract, where the reductions in my salary each year were the premiums and the $12 million is the payout.”

So maybe Meche should have taken the money. But at the same time, theoretical law and economics doesn’t dictate our societal norms, at least not yet. As he said, “It’s just me getting back to a point in my life where I’m comfortable. Making that amount of money from a team that’s already given me over $40 million for my life and for my kids, it just wasn’t the right thing to do.” It sounds like he just decided he was happier without the $12 million than he would have been with it.

Card dealers, on the other hand, would have kept the money, as discussed in a paper by John List. The main point of List’s paper is that people may show preferences for fairness in lab experiments, but those same people — in this case, card dealers — will revert to pure economic self-interest in real-world transactions. By contrast, other studies have shown evidence of real-world preferences for fairness, for example in George Akerlof’s study of cash posters. I find it not particularly surprising that card dealers do not show preferences for fairness in the real world. Their business is predicated on making money through zero-sum transactions: paying less than something is worth and selling it for more than it is worth. Kind of like Wall Street traders.

34 responses to “No No No! It’s Already Priced In!

  1. The sad thing about Meche’s decision is that it will free up the money to give to someone who cares about fairness less than Meche does.

    Our society selects against those with a sense of fair play. Frankly, I find it amazing that they are not already extinct (and civil society with them). Give it another generation or two…

  2. Seconded.

  3. Tom Drolshagen

    Why not make Meche the head of the SEC?

  4. In behavioral economics, it’s called “contrafreeloading”, and is a powerful effect.

  5. Should have kept the money and donated it all to nonprofits supporting youth sports. :)

  6. Tom Drolshagen

    I agree. Get the kids off their posteriors and munching junk food and out getting exercise.

  7. “paying less than something is worth and selling it for more than it is worth. Kind of like Wall Street traders.”

    Hmm? When traders want to buy stock, someone sells it to them. When traders want to sell stock, someone buys it from them. All at an agreed price. The very epitome of selfless behavior – helping a fellow trader to buy or sell! Someone’s got to do it, it’s a public service !!

  8. You wrote, “card dealers” twice. Did you mean car dealers? (I was unable to download the paper.)

    Thanks.

  9. A guy with integrity. I would dissuade him from seeking employment on Wall Street, however.

    Incidentally, Larry Bird, ex-Celtic, did a similar thing at the end of his career..that is, he left without taking $$$ contractually due to him.

  10. ..or maybe the “recipient” of the 12m will do something even greater with it–like support inner city youth development programs? Perhaps naive, I will hold out for this action creating an ever-inflating “pay it forward” economic benefit. Rather than be cynical, this guy’s actions speak volumes and provide a powerful counter-argument to the excesses of modern professional athletics. Let’s just hope others are watching and listening. More athletes might give more of their pay up for valuable social investments and programs, and more budding athletes might look to Meche as a role model, not blood doping bicyclers or steroid-swallowing batsmen…–L

  11. I really hope you are being sarcastic.

  12. @ Woop

    Larry Bird (Johnny Most) my best days in Boston.

    “Drive” by Larry Bird

  13. “do not show preferences for fairness in the real world” – and then directed to those that claim moral superiority – What would Jesus do?

  14. Correct. He is giving his team the 12 million as a gift. The motivation is reciprocity. He obtains a reputation for generosity and fairness that will be of great value to him in his social circumstances.

  15. Bayard Waterbury

    I’ve read all of the comments, but it appears that something is missing. What is right about a society that pays athletes $12 or $40 million to do something which only has value as entertainment, and pays the very best teachers $80,000 for imparting the most valuable information on generations. I am not, nor I ever want to be, a communist, and, in fact, I’m not for most income redistribution, but maybe I need to rethink that. Capitalism is, nowadays, proving to be far more evil and corruptive, in many ways, than fair and reasonable. The basis of all human economic progress is being paid more for adding more value and has been since humans began to form societies. And yet, from that standpoint, there were always counterveiling forms of corruption which used power and politics to bend the natural curve in unnatural ways. I am not opposed to paying athletes what their social value dictates, but not to the detriment of others making equal or greater contributions. Are Wall Street’s banking elite worth more than a good doctor, plumber, electrician, teacher, or auto mechanic. One could easily argue that they are worth far less, since their services generally seem to result primarily in their own personal enrichment to the detriment of the greater society. Plutocrats will, of course argue differently, but then that’s what they are paid to do.

  16. @ James Kwak “paying less than something is worth and selling it for more than it is worth. Kind of like Wall Street traders.”

    Well let´s hope for Kwak’s sake that they keep on doing so in Wall Street. I would not like my country´s Wall Street professionals to pay more than something is worth and sell it for less.

    Just for a starter I have someone in my country (Venezuela) who strangely calling himself a socialist sells all gas in Venezuela for about $ 8 cents per gallon and with that takes away about 10 of GDP from those who have nothing of nothing giving it to those who drive cars… or perhaps spend their days in the traffic jams that 8 cents per gallon create.

  17. Seconded !!

  18. On the facile face of it, it appears as worthy endeavour until the hidden business is opened up and sees the criminality and fraud at its base. Wake up ! The banksters have us by the throat.

  19. Right on ! What is a person truly worth ? Their money and wealth? Their integrity and honesty?

  20. James,

    This must be not the whole story. It is not only the player giving up a lot of money, but also his manager (I guess). And he is not donating to charity, this is a major league baseball franchise, ie an entertainment business (be it that there is some altruism in the clubs past), although not a very successful one financially.

    What was in it for him?

  21. @ BW: “What is right about a society that pays athletes $12 or $40 million to do something which only has value as entertainment,”

    Personally, I don’t have a problem with actors, musicians, and athletes making piles of money. Their careers are usually short, they put seats in the seats (so to speak), and when they can no longer do that they are gone and usually forgotten. No golden parachutes.

    Besides, is not entertainment a valuable diversion, especially in these troubled times? I watched the SF Giants go all the way last year, enjoyed every second of it, and never once thought about the high salaries of the players. It was pure escapism—and worth it!

    As for the exorbitant compensation of “Wall Street’s banking elite”, you’ll get no justifications from this corner. They’re in a league of their own. They’ve granted themselves 100% immunity against market forces. When they succeed, they loot the company. When they fail, they loot the company. When they fail disastrously, they loot the government. To modify an old Wall Street advertising slogan: “They make their money the old-fashioned way—they STEAL it.

    BTW, if your question was intended to be, “What does it SAY about a society that pays athletes….”, well, that’s a whole different ball-game.

  22. It seems to me that one of the problems with economic theory is that it sometimes leads people to forget that intangible things like self respect can actually have value–in real life people often aren’t perfectly rational value maximizers, and if Mr Meche deems being able to look at himself in the mirror to be worth $12 million, then more power to him.

  23. michael johnson

    James,
    Does the work of Elinor Ostrom on collective action theory enter into any of the behavioral economic discussions? It goes way beyond thinking in terms of “non-economic preferences” and “fairness.”

    michel

  24. Double-down on that trouser. Hear that argument all the time, “Athletes, Hollywood, The Stones, etc” all make too much.. Yeah, probably, but we go to see Them, they don’t lord over us, control our politicians, escape justice. Banks take(steal) our money, The Fed’s ‘money’, pis.. it down the drain, then use extortion tacts to keep regulation away. Not quite the same.

  25. I think this is assuming that Gil’s bosses were smart enough to see the potential risk and price it in, which one would hope at these figures, but I think is probably a dumb assumption to make.

    While it is true one cannot predict Gil’s morality here, one also cannot predict the stupidity of people who are in trusted enough positions that they should not be.

    Consider for instance that at the height of the housing boom, just before the crash in `08, that the “smartest men in the room” were still layering on risk like hot cakes.

    No, “pricing in” implies “perfect markets”, logic, and sanity, all of which recent history very clearly denies.

  26. It actually hurts to read that. Primarily because its generally true.

  27. Elsewhere people have suggested that that he receives slaps on the back for being a good guy, a good sport.

    But this is professional sports. Doesn’t it seem more likely that his accountant got together with the team accountant and they figured out a way for both of them to lose less money? By not accepting the money, the money is freed up for other people. It would be fun to follow the money here.

  28. “The basis of all human economic progress is being paid more for adding more value…”

    It also depends on your definition of “value”. Traditionally this was defined by actual tangible goods that do something for you. Feed you, clothe you, protect you from the elements and predators while you sleep. Somewhere along the way, we decided we didn’t like that anymore.

    America has become addicted to the idea of making money off ideas and entertainment or just shuffling “money” (bits on a screen) around. All are abstract concepts that don’t actually exist. They would have no value were it not for the belief that they do, and humans instinctively grasp that fact, hence the reason most of us tend to balk at the pay professional athletes receive.

    Personally I feel people should play more sports instead of watching pros do it. It’s more fun, better for you, and great for your social life. Might even give a few fat, beer-swilling former jocks a chance to relive their high school glory days too. ;-)

  29. I’m with you, oh definitely. It’s even worse than just teachers and doctors, although that would be bad enough.

    Those of us that work in language and cultural preservation end up having to scramble to put $ signs on whole cultures, languages, ways of living – you know, part of the inherited history of humanity, 10,000 year old language groups, people who have lived in a coherent culture constructed over thousands of years, and so on. If we fail to put $ signs in the right places, then we get no hearing in the public arena. ‘Value’ is defined in the narrowest of terms, which would be bad enough if the same people who lord this reductionist definition of ‘value’ over all our heads didn’t then turn around and cry foul when their own ‘value’ evaporated…

    Put in specific terms – we typically can’t come up with $10,000/yr to fund a project for children to have a school in their own language (Zapotec) in Oaxaca, or $800 to help support an old person to tell the story of their culture (e.g. Blackfoot, Sarcee, Cree, etc.) in Alberta, but we can throw $12million at someone who hits a ball with a stick. When that old person dies – the culture is gone forever, never to be found again on this earth. But I’m pretty sure I can find someone else to hit the ball with the stick – there’s a line a mile long. How does the irreplaceable thing not count as ‘value,’ while the mile-long line does?

    Some economists and Wall-street types seem to like to talk like this is just an agentless ‘machine’ doing this. The ‘laws’ of economics and all that. It’s not true – we’re building that world on purpose. I guess I hope we like it when we get it. There’s going to be a lot of the same thing, and not much of anything else.

  30. Good luck with that.

  31. $80k for teachers? Where? Sign me up!

  32. Why in the world would he give the $12 million back to the KCR instead of giving it to charity? His notion of fairness seems really warped.

  33. desi girl - doing god's work

    Kings, Kings, I am asusming to don’t use a credit card or a bank or an atm. If the entire population of the us kept their cash at home, in their mattress, and paid for cash, then we would not need banks.

  34. the reasons can be many for him to give the $12 million back. but in this instance even i feel its a bit foolish