Comparative Advantage in Baseball

Tuesday, December 15, 2015

It seems a majority of teams like to play the market. This can work considering there is always the potential to find undervalued prospects, but the market is becoming increasingly efficient. By this I mean more teams are using the same valuation procedures to make transactions. For you finance people out there, you will understand this as efficient market theory. In layman's terms it means that prices of securities fully reflect all of the information available at any given time making it theoretically impossible for anyone to find an undervalued stock. This theory suggests that only executives within the company know the true value of their stock. In my own personal opinion this theory is only "sometimes" accurate. As Warren Buffet said, "The stock market is efficient until it's not." At this point the stock market of baseball is still somewhat inefficient meaning that there is still value to be had. However, as mentioned in a previous post, Moneyball 2.0, clubs are beginning to look to different strategies - besides the typical undervalued player - to create advantages and sustain success. Another example of this trend can be found in Jeff Quinton's piece, Winning by Design, where he demonstrates and proposes ways clubs are and should be using new modern management techniques to construct their organizations. I want to take the next few moments of your time to explain another way teams can continue to succeed in an increasingly efficient market.



My theory revolves around the notion of specialization and in the spirit of building teams from within. I am going to look at the positive advantages and negative outcomes and you can be the judge of whether the baseball market could support this idea. I will admit the idea is a little... out there and will not be surprised if totally found to be irrelevant, but regardless here goes.

Let me first tell you a little about the economic term comparative advantage and hopefully you will catch on to where I am going with this. Many times this term is referred to in a global context. The principle suggests that world output would increase if countries determined what goods and services they should specialize in producing. The concept goes on by claiming that countries should specialize by allocating their scarce resources to produce goods and services for which they have a cost advantage relative to other countries. This could mean that one country is more cost efficient when it comes to producing a good than another country. Take Columbia and Costa Rica for example (Sorry, Narcos kick). Both countries produce a significant amount of coffee and fruit. For the sake of the example let's say Columbia produces coffee more efficiently and Costa Rica has the efficiency advantage in fruit production. The principle of comparative advantage would say that Columbia should specialize more in producing coffee and Costa Rica should specialize in fruit and that by doing this it would optimize output. The more quality products in the market the better off everybody becomes.

Now replace the word "countries" with "baseball teams" and you will probably guess where I am going next. Using this principle in a baseball context gets tricky and like I said I am going too lay out the advantages and disadvantages. I think the best way to understand this concept is through an example. I will roll with the example we started with and replace Columbia and Costa Rica with the Cubs and Yankees (two of my favorite teams). Also for this example I will use pitchers and hitters instead of coffee and fruit. Note that in a real world setting the hitters could be broken down by position and pitchers by starter and reliever, but to simplify things I will stick with pitchers and hitters.

For this idea I am viewing the farm system of major league baseball teams in the same manner as countries. One produces some good or service the world needs and the other develops baseball players. Take a look at the matrix below. I am assuming that teams - in this case the Yankees and Cubs - already have some resources in place that make them more efficient at developing a certain type of player. This could mean the team has better pitching coaches than hitting coaches. It might have to do with the team philosophy or regiments; meaning the team workouts benefit one type of player over another. Also, it could be that the club employs amateur scouts that can better evaluate either pitchers or hitters.


These are made up numbers, but what it says is that in a given year the Yankees have the ability to bring up four major league ready hitters or one pitcher. The Cubs can bring up five major league ready hitters or 4 pitchers. I am assuming there is some level of unified certainty by each team with regards to judging whether a player is major league ready. In this case, the Cubs have the absolute advantage in producing both pitchers and hitters, but it has a comparative advantage in pitchers because it seems relatively better at grooming that type of baseball player. The Cubs are 4 times better at pitchers and only 1.25 times better at hitters.


The widest gap lies with developing pitchers. This is why the Cubs should specialize in developing pitchers leaving the Yankees to develop hitters. The economic theory - applied to baseball - would suggest that if teams applies the principle of comparative advantage, combined output will be increased in comparison with the output that would be produced if the two teams tried to become self sufficient and allocate resources to the production of both pitchers and hitters. Using this example, if the Yankees and Cubs allocate resources evenly both pitchers and catchers combine output is 7.5 major-league-ready players.

Cubs = 2p + 2.5h; Yankees = .5p + 2.5h
Output = 2.5p + 5h (= 7.5 major-league-ready ball players)

Please forgive the inaccuracy of this chart. I free-handed it.


If both teams specialized based on their comparative advantage, total market output would be 8 major-league-ready players.

Cubs = 4p + 0h; Yankees = 0p + 4h
Output = 4p + 4h (= 8 major-league-ready ball players)

I can already hear the gears grinding in some heads and people realizing that this would not directly apply to baseball. I am with you, trust me. Just follow along a bit longer and I will get to my point.

Regardless of whether this is possible in the real world - to get an idea of whether specialization and trade amongst teams would really work we must look at the production possibility frontier gradient (PPF). The gradient reflects the opportunity cost of production. In our Yankees/Cubs example it helps us understand the trade-offs of increasing focus on developing a certain type of player. Looking at the chart below, to develop +1.25 major-league-ready hitters the Cubs must give up the opportunity to produce 1 pitcher. The Yankees on the other hand only gives up .25 pitchers to produce 1 hitter. The opportunity cost of producing one major-league-ready hitter for the Yankees is -.2p (-.25/1.25) and for the Cubs it is -.8p (-1/1.25). What this is telling us is that the Yankees should develop as many hitters as it can and the Cubs should develop pitchers.



For specialization and trade to be economically more efficient the teams must have different PPF gradients which means different opportunity cost ratios. A team would have a comparative advantage only when the gradients are different. If the PPF gradients are identical, no team would have a comparative advantage. If this were the case it would not make sense to trade with teams. As we know, this is not the case since teams trade with each other regularly. In our example, it does make sense because the Yankees and Cubs would be feeding the market more ready-to-play prospects. Since every team needs hitters and pitchers it would be in the teams best interest to make mutually beneficial trades.


Why this doesn't work (exactly)

In a perfect world teams could specialize in acquiring and developing one type of player and then participate fairly in trade with the other teams. Going back to efficient market theory - as it would apply to baseball - nearly every team has access and is using all information (sabermetric, player tracking, scouting) to build and run ball clubs. Teams that once had an advantage in one or more of these categories are now finding them extremely difficult to leverage. That being said, the market is still inefficient and the system is set up to where teams rarely, if ever, want to collaborate for fear of losing inside secrets.

Another reason why applying the concept of comparative advantage would not work is because players and their development are not perfect. Even with some of the most efficient predictive models out there, each year there are players who over or under achieve. In order to understand and apply the concept to baseball there would need to be a high level of certainty about the current and future value of a player.

This brings up another criticism. Relative prices are not taken into account in the simple theory of comparative advantage. For example, if the price of hitters rises relative to pitchers, the benefit of increasing the output of hitters increases. For a team who specializes, they run the risk of building up a surplus if their pool of players becomes less valuable by no reason other than a decrease in their prices. Take the Cubs in real life. We all know they had a surplus of hitters relative to other teams. What if the player market was already saturated with this type of player? It would mean their specialization in hitters would not pay off that season at least with regards to being able to trade them.

Finally the principle of comparative advantage was formed from a simplistic two entity model. The world is more complex. Teams not only develop players they must acquire players from around the world, find better ways to use their players and it gets tough to put a value on all of those abilities. Basically what I am saying is that their are many other external costs associated with trade that comparative advantage does not take into account.

Takeaways

The fundamental theory of comparative advantage can still be said to provide 'shape' to the pattern of player development, acquisitions, and trades. Example, if you are another team and you know that the Cubs currently specialize - not necessarily developed -  in infield hitters you may want to consider - at least short term - in specializing in some other type of player. Don't get me wrong, teams will always need to maintain a minimum level of player production for all types of players, but it might not always be the most efficient route to apply every resource to acquiring and developing all types of players. This seems counter intuitive considering it is the goal of farm systems to build a well-rounded diverse group of players. However, if a team understands the market landscape they would know which type of player other teams are specializing in and use that information to build a strategy for their own player acquisitions and development. It would, at the least, give teams the ability to know the most efficient way to acquire the players they need to succeed.

This whole idea came from my belief that in the future teams will need to find other ways - besides the current "moneyball" tactics to create a competitive advantage. As it stands the current method teams use in an attempt to create advantages could be considered operational effectiveness. They are improving the efficiency of their team by means of in-game strategy (lineup optimization, defensive shifts, etc.) along with finding under-valued assets that can be considered close substitutes to well-known above average players. They use these "moneyball" tactics to optimize the performance of their team using the fewest resources possible which in business terms is loosely related to operational effectiveness. Michael Porter, famed strategist and Harvard professor, states that operational effectiveness is necessary but not sufficient with regards to creating a competitive advantage. In other words, it is not a sustainable strategy and in my opinion we are seeing this play out somewhat.

Teams are becoming little closes of each other and it will eventually be - if not already - a race down the path to mutual destruction. I believe that smart people in baseball realize this and will begin to expand their club's master plan. Understanding strategy and economics - as it can be applied to baseball - could be a new way for baseball organizations to create advantages as Jeff Quinton of Baseball Prospectus and others have suggested. I am by no means saying that the theory of comparative advantage is a strategy, but understanding concepts like this will help teams formulate strategies. However, this time team's strategies may lead to sustained advantages.

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