Thursday, October 13, 2011

NBA Lockout: a mechanism for avoiding value destruction in disputes

The recently-announced NBA labor dispute will eliminate at least the first two weeks of the season.  On the face of it, such disputes should be rare.  The total pie (i.e. gross profits to be shared) is huge, both parties have expert negotiators to represent them and both parties incur substantial costs when they are not able to reach agreement. Today's post will look at how disputes of this kind arise generally (and not just in sports) and how they are made more likely by the structure of payments typical in sports.  Finally we'll look at a mechanism that could reduce the risk of destructive escalation going forward.

Let's start with a basic problem that arises when two parties must agree how to divide a large pile of money.  This seems like a wonderful "problem" to have, but it's surprisingly easy for it to go wrong.  To see why, let's play a game called "Ultimatum."

There is $1,000,000 on the table.  You get to propose a split.  I can then either accept the split, in which case the money is divided as you proposed, or I can decline it, in which case neither of us gets anything.  This structure puts you into a very powerful position.  If, for example, you propose that you get $900,000 and I get $100,000 (a very slanted split) my choice is between $100,000 and spite.  Unless I'm a very spiteful person, I'm going to take the $100,000.  If you know I really need cash you could propose a split of $990,000 to you and $10,000 to me, capturing 99% of the value on the table by leveraging your position.

Now imagine a more "normal" negotiation over how to split a million dollars.  We'll call this game, Even Steven.  We have an hour to negotiate; if we haven't struck a deal by then neither of us gets anything.  Neither of us has any advantage; if you suggest a split that favors you I can say "no" without losing anything.  Most likely (and this is supported by practical experience and academic studies) we'll end up splitting the pie evenly and each taking home $500,000.

Now, if you're choosing between a game where you win $900,000 and one where you win $500,000, which would you rather play?  Most of us would rather play Ultimatum, which is where commitment dynamic into play.

Suppose we're playing Even Steven and you come up with a way to convince me that you'll refuse any deal that doesn't give you at least $900,000.  Perhaps you sign a contract binding you to lose $1,000,000 if you agree to any worse deal.  Perhaps you have a reputation for doing anything to keep your word and you swear on your honor that you don't take a penny less.  Whatever the specifics, if you can make a credible commitment to take nothing unless you get $X, then you've changed the game from Even Steven to Ultimatum with you in the driver's seat.

The same dynamic happens in real-world negotiations.  When the pile of money to be divided is big or the consequences of failing to reach agreement are disastrous there is an incentive to claim a big share of the pie by committing yourself to an aggressive bottom line.  We saw this play out in the recent debt ceiling negotiations -- Republicans made very public commitments not to accept any tax increases precisely because saying it privately wouldn't have committed them.  That put Obama and the Democrats in a position where if they insisted on tax increases they risked finding out that they were playing Ultimatum rather than Even Steven.

Even if you don't have a mechanism to create commitment, you can try to play Ultimatum by appearing committed.  Using this approach, a negotiator stakes out a very aggressive position and either sticks to it or makes tiny concessions (which is generally a signal that someone is near their bottom line).  "OK, you won't accept me getting $900,000 to your $100,000?  I can go $880,000 to $120,000."  If both parties do this, of course, the negotiation can quickly break down into acrimony -- neither side trusts the other, the parties are far from agreement, and progress looks remote.

Things get worse when we add ego (and I think it's fair to say that professional athletes and the owners of NBA teams all have healthy egos) and different senses of what's fair to the mix.  If it's possible for people to fail to divide a pile of money on the table (and it most certainly is), imagine how much harder it gets if each person think that they deserve 70% of that pile.  People commonly overestimate their contribution to any shared effort; it's safe to assume that the players and team owners have very different views of how much each of them "ought" to get from the revenues generated by the NBA enterprise.

All that would be bad enough, but sports leagues often add one more structural problem to the mix. Players typically earn salaries that are paid throughout the season, while owners earn a relatively high percentage of their income during post-season television.  This means that each side has a window in time where the pain of a fight is greater for the other side than for themselves.  For this reason, lockouts are more likely to happen at the start of the season (more painful to players) and strikes more likely later in the season.

Two Different Types of Value Destruction

If labor and management, players and owners or whatever parties share in creating a pool of value cannot agree on how to divide it, they typically stop creating that value -- temporarily.  Strike, lockout, "taking a break" in the relationship, the basic dynamic is the same.  Each side stops receiving its current share of value creation until the dispute is resolved.

While in some sense any value destruction is unfortunate, a good case can be made that at least some of it is necessary, too.  If the current division of value favors one party over the other, that party may need leverage to bring the other party to the negotiating table.  Even in the game Even Steven it's useful to have a deadline, since otherwise negotiations could drag on indefinitely.

It's worth distinguishing, however, between two different forms of value destruction.  The first is having to forego current value that would have been created if no dispute takes place.  In a strike/lockout, for example, workers don't get paid* and owners don't get the profits the business would normally earn.  Ideally agreements would be resolved before a strike is necessary but having that stick available is healthy and probably unavoidable.

Another source of value destruction is damage done to the enterprise itself by the strike.  If a company loses key customers permanently because a strike disrupted its service to them, then when labor and management agree on how to divide the pie they are sharing a smaller pie -- potentially much smaller.  As Hall of Fame goalie Ken Dryden put it (discussing the 2004-5 NHL strike), "You never want to give a fan a chance to find out whether it was passion or habit."  If fans get turned off watching players and owners (each group being far richer than the typical fan), future revenues can be significantly damaged.

A Mechanism to Reduce Value Destruction

So now we have a conflict.  The ability to inflict economic pain is a useful tool, without which a division that favors one side may be impossible to resolve because that side won't come to the table.  At the same time, both sides have an incentive to limit the pain to lost revenues during the negotiation itself rather than killing the golden goose.

In theory, this can be avoided by replacing an actual strike with an artificial one.  Players and owners contractually would commit to pay money into a pool in the event that they are unable to agree on contract terms -- with the payments designed to simulate the revenues that would have been lost in the event of a strike.  Instead of an actual strike/lockout, however, play continues -- and fans, instead of being disappointed and potentially putting their entertainment loyalty elsewhere, get to watch the teams they love compete.  Best of all, instead of the losses being "real" losses they could be donated to charity.  Imagine the positive press if as a result of a contract disagreement the NBA were announcing that it would be donating a large sum of money to improve inner-city parks or to provide sports equipment to low-income public schools...instead of canceling games.

Such a solution would be unusual, but far from impossible to implement.  A trusted third party (e.g. McKinsey & Co.) could be brought in to do the analysis on how much each side would pay and to provide a mechanism for re-evaluating the system as revenues change in future years.  All it would really take is a willingness to adopt an unusual agreement on how to resolve future disagreements.  The end result would be superior for all parties -- owners, players and fans.

* Workers typically get paid by their union, but not at full wages and in any case this is money come out of their collective pockets rather than from the company.

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