How Compensation Picks Stifle Free Agent Salaries

The Major League Baseball Players Association and owners of Major League teams have just completed a new Collective Bargaining Agreement, as the previous agreement expired this December. One of the most underrated differences being discussed among the many changes is how the two sides resolved “compensation” for teams that lose free agents. The previous rule in recent years stated that when a player is ranked as an elite (“Type A”) player by Elias, the team that signs him forfeited their first or second round draft pick to the player’s previous team, and the player’s previous team picked up an additional “sandwich” pick between the first and second rounds as well (as long as the previous team offered salary arbitration to the player). When a semi-elite (“Type B”) player signed with a new team, then the previous team only received the sandwich pick, but no pick was transferred between teams.

On its face, it sounded like a fair gesture to maintain parity, but it really only served one main purpose—to act as a restraint on salaries and drive down the prices teams would pay for players on the open market. The “compensation pick” that a team forfeited when they sign a new player is actually what economists would consider a tax. When an employer has to surrender something valuable other than salary (cash or otherwise) to hire an employee, this has the effect of suppressing salary offers.

The amount that salaries are held down depends somewhat on alternatives. Suppose you increase taxes heavily on Jane, a working mother with young children. Jane may consider her time better spent at home with kids, rather than getting less money to work while day care costs just as much. When speaking amongst ourselves (or torturing you in lectures), we economists may describe this by saying “her labor supply is elastic.” In other words, changes in her after-tax wages affect the number of hours of labor she supplies.

However, regardless of whether Jose Reyes’ new team has to surrender a draft pick to sign him, he probably isn’t going to quit baseball. He’s not going to take his talent to South Beach…okay, maybe he actually is, but it would be to play baseball and the Marlins would have to surrender a pick to sign him as well. He’s a little short to play basketball for the Heat, so economists would say that Jose Reyes’ “labor supply is inelastic.” He’s playing all 85 games he’ll be healthy for next year, whether his salary is depressed by the new CBA or not.

This is all important, because it means that if all teams have to give up draft picks to sign Jose Reyes, the whole tax falls on him. A tax on Jane’s wages would probably fall mostly on her employer, who presumably would have to increase her before-tax salary to retain her, but Jose Reyes is going to be offered less money by all 30 of his potential employers when there is a tax.

Re-signing players under the current expiring CBA didn’t help teams get around the problem either. By signing a Type A free agent of your own, you actually forfeited two picks—the one that you would have gotten if someone else signed your Type A free agent, and a sandwich pick! Consider the Phillies, who signed Jonathan Papelbon to a four-year $50 million deal last month, after previously being rumored to have offered a four-year $44 million deal to Ryan Madson. It sounds like they’re paying more for Papelbon, but the difference is actually ambiguous. By signing Madson, the Phillies would have surrendered no picks, but received no compensation picks or sandwich picks. By signing Papelbon, the Phillies will apparently receive a pick around the same spot as that of the team that signs Madson and a sandwich pick, while giving their first round pick to the Red Sox. How much is that sandwich pick worth? We’ll see that the answer is actually pretty close to the $6 million difference between the two deals.

Sky Andrecheck provided a useful tool several years ago, when he released the Draft Pick WAR Calculator, which included estimates of the production of players during their first six years (before free agency). Utilizing this, adjusting it for the replacement level used at FanGraphs, and estimating the amount paid for players in their first six years relative to the price paid for players on the free agent market, I actually came up with a pretty nice estimate of the value of picks in terms of wins. The most valuable pick eligible for compensation is the 16^th pick, which is worth about 2.8 WAR, net of salary, but average value of a compensation pick is about 1.8 WAR.

Of course, players require signing bonuses, so I needed to estimate these as well. I picked values ranging from about $200K to $1.8MM, depending on the pick.

However, these WAR come in the future, and typically about six years in the future, so these will need to be discounted—teams clearly value present wins more than future wins. So the question that I was left with is: “How much should I discount future wins?”

The answer is not actually as abstract as the question sounds. If you look at all players who neither cost their teams draft picks (real or re-signings with opportunity costs), nor provided their teams with draft picks at the end of the deal, the average amount spent per actual WAR produced was about $5.78 million through 2007 to 2011. On the other hand, the average amount spent per WAR for players that cost draft pick compensation (or provided it after the deal ended) was about $4.96 million. The difference represents the net cost of forgoing draft picks.

Teams spent about $5.33 billion on players in such deals through 2007 to 2011, and received about 1,075 WAR. However, when you add up the dollar value saved from not spending on signing bonuses, the $5.33 billion spent on players really goes down to $5.13 billion. The overall number of wins surrendered via draft picks was about 323.5 WAR, coming about six years after a deal was signed. If teams discount future wins by 10% per year, then this would be valued at 182.6 current WAR.

That 10% discount rate would make the price of WAR for players who cost their teams draft picks approximate $5.75 million, almost exactly the same as $5.78 million they paid for players who did not cost draft picks!

So, now that we can say that teams value future WAR at about 9.3%, we know that the WAR value that the Phillies gained by signing Papelbon and netting a sandwich pick was about 1.0 WAR exactly. The price of 1.0 WAR is about $5.8 million, but also cost them about a $1 million signing bonus. So what’s the value of the extra pick from signing Papelbon instead of Madson? The answer is about $4.8 million, just shy of the $6 million difference between the two deals. They paid about the same either way.

Using this method the hidden costs are:

Surrendering 16^th overall pick: $8.3 million

Surrendering 20^th overall pick: $7.3 million

Surrendering 30^th overall pick: $5.7 million

Surrendering 50^th overall pick: $4.1 million

Surrendering 60^th overall pick: $3.7 million

Surrendering 99^th overall pick: $2.6 million

Re-signing Type A Free Agents: $9.6 million

Re-signing Type B Free Agents: $4.8 million

Draft picks are important. Not even the Yankees can win using free agents alone, and every team knows this. Getting cost controlled talent is essential, the expiring CBA allows teams to suppress salaries by about 9.3% overall for free-agency eligible players by requiring draft pick compensation.

Overall, I estimated that between 2007 and 2011, there were about 147 players affected by draft pick compensation, either by costing their teams picks, or requiring that their old teams forego the opportunity to get picks by not signing them.

The new CBA requires that teams make an offer of a one-year deal with a salary equal to that of the average of the top 125 salaries the previous year. I estimated the average cost of a WAR using both actual and draft pick costs and estimated how many would have been worth more than this salary their first year after hitting free agency. The answer was 145 players—basically the exact same number of players currently affected! Someone in those negotiations knew what they were doing.

This may have served to change whose salary was going to suffer as a result of these costs, but it’s not going to change the total market at all. The players had been asking for this tax on their salaries to be removed or diminished throughout the negotiations, and collectively, they ended up right what they started on compensation. Maybe in five years, they can try again.