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1975

IN THIS ISSUE . . .
Anatomy of a "Fiscal Crisis"

. . . Rather than pass the tin cup for outside
funds each time a "fiscal crisis" erupts, large
cities in particular should start seeking a
more rational approach to financing govern­
ment expenditures.
Rising Medical Care Expenditures:
A Growing Role for the Public Sector

. . . Health care expenditures are becoming
an increasing share of our GNP, with the
public sector financing a growing share of
all medical payments.
Restrictive Labor Practices in Baseball:
Time for a Change?

. . . Economic analysis of the baseball labor
market sheds some light on the effects of the
player reservation system and possible ways
of modifying it.

On our cover: In Philadelphia at Pier 11 on the Delaware River is the U. S. 5. Olympia, one
of the few reminders left of the Spanish-American War. Flagship of Commodore (later
Admiral) George Dewey at the Battle of Manila Bay in May 1898, she is the oldest steel Navy
vessel in existence. A museum aboard contains pictures of the Olympia, uniforms of officers
and enlisted men, and memorabilia of the ship.
BUSINESS REVIEW is produced in the Department of Research. Editorial assistance is pro­
vided by Robert Ritchie, Associate Editor. Ronald B. Williams is Art Director and Manager,
Graphic Services. The authors will be glad to receive comments on their articles.
Requests for additional copies should be addressed to Public Information, Federal Reserve

http://fraser.stlouisfed.org/ of Philadelphia, Philadelphia, Pennsylvania 19105. Phone: (215) 574-6115.
Bank
Federal Reserve Bank of St. Louis

Anatomy of a
"Fiscal Crisis"
By Anthony M. Rufolo

tified, or are some city administrators simply
rebelling against the constraints of their
budgets?
Taxpayer Smith may forsake the paved
sidewalks of the city for the manicured lawns
of suburbia for any number of reasons. He
may commute a greater distance for more
open living space. He may want his children
to attend a suburban school. If he moves
from one suburb to another, generally no
one would care. But a move from city to
suburb makes him another statistic to
furrow the city mayor's brow. The likeliest
candidate for such a move is the relatively
wealthy taxpayer.1 For example, Smith's con­
tributions to the city's coffers may be more

Although the fiscal plight of New York City
has been making headlines, most local
governments now complain that expendi­
tures are growing faster than taxes. Many
residents demand increased services despite
rising costs, but they quickly rebel at at­
tempts to raise more tax dollars. Nearly
everyone wants more goods and services
for less money, so these demands don't seem
unusual. It's one way for citizens to remind
City Hall that every expenditure decision
involves a budget tradeoff. After all, as
economists never tire of pointing out,
resources are limited and budgets limit
their use. However, mayors in certain
areas— particularly central cities— fearthat if
they fail to maintain the same level of services
or to clamp a lid on taxes, the exodus of jobs
and wealth to the suburbs may accelerate.
Many of them call this a "fiscal crisis," conjur­
ing up visions of nothing but abandoned
buildings and jobless poor. Is such alarm jus­




'One author found that "between 1959 and 1969, the
median income of central city families dropped from 89
percent of that of suburban families to 83 percent." See
joseph A. Pechman, "Fiscal Federalism for the 1970's,"
National Tax Journal 24 (1971): 285.
3

JUNE 1975

BUSINESS REVIEW

riers such as zoning restrictions.3This popu­
lation shift then affects government budgets,
and a quick review will show that cities' tax
bases relative to expenditures are not keep­
ing pace with the suburbs'.
The property tax is the primary source of
most locally raised revenue. In the early 70s,
property taxes accounted for 82 percent of all
tax revenue of local governments in met­
ropolitan areas and 40 percent of their total
revenue from all sources.4 However, this im­
portant component of the tax system has its
base rising more slowly in central cities than
in the suburbs. For example, real estate val­
ues in Philadelphia increased by 29 percent
from 1962 to 1972 while those in the sur­
rounding counties of Delaware, Montgom­
ery, and Bucks posted increases of 38, 77, and
100 percent respectively (see Table 1).
At the same time population has been
growing fairly fast in the suburbs while it has
actually declined in Philadelphia (Table 2).
The result is that tax base per person has
grown at a similar rate for each county (Table
3). However, expenditure per person is rising
fastest for Philadelphia (Table 4) so that even
adjusting for population, total expenditures
are growing faster in Philadelphia (Table 5).
Thus, while expenditures are rising faster
than the value of the property base in all four
counties, the difference is largest for Phila­
delphia.
Several major cities have turned to a wage
or income tax to pay for services without in­
creasing the tax burden on real estate. In
Philadelphia, for example, between 1962 and
1972 property tax revenues increased by less
than 45 percent while total tax revenue al­
most doubled. In large part the wage tax took
up the slack. Unfortunately, however, shift-

than it actually costs to provide him with
government services, so he pays for services
for relatively poor taxpayer Jones as well. This
redistribution of income provides an incen­
tive for Smith and others like him to leave the
city, thereby putting increasing pressure on
city budgets. Thus, income redistribution at
the local level may be a major force behind
the "fiscal crisis."
So far, no majorcities have folded. Perhaps
the danger signals were heeded before the
situation became hopeless. Recently Federal
revenue-sharing funds have helped relieve
the pressure on city budgets. But the under­
lying source of the problem may still be with
us. An analysis of what makes a fiscal crisis is
in order, so that the pros and cons of pro­
posed solutions can be weighed intelligently.
Perhaps there is a solution which attacks the
source of the problem rather than its
symptoms.
CITY VERSUS SUBURBS

Every government has budget constraints,
so why must only major cities face crises?
One reason for the difference in ability to
cope is that suburban communities have
been more successful in attracting the
"Smiths" and banning the "Joneses."2 This
creates a problem for the city because the
poor require relatively more services from
government but have less ability to pay. More
low-income residents force a larger tax bur­
den on city businesses and wealthier resi­
dents or shift services away from them, or
both. Some of these businesses and indi­
viduals avoid this increased burden by just
moving to the suburbs. This movement in
turn leads to greater tax burdens and/or de­
creased services for those remaining in the
city. The poor don't emigrate because of in­
adequate low-cost housing or poor public
transportation in the suburbs as well as bar-

3A recent New Jersey Supreme Court ruling has as its
intentthe removal ofthese barriers with respectto hous­
ing, but its impact cannot yet be determined. See "Zon­
ing and the Citizen” in the New York Times, April 1,1975.
4U.S. Department of Commerce, Bureau of the Cen­
sus, 7972 Census of Governments, Local Government in
Metropolitan Areas, p. 8.

2There are exceptions, of course, and those suburbs
which have not been successful at this face the same type
of problems as the central cities.




4

FEDERAL RESERVE BANK OF PHILADELPHIA

TABLE 1

THE TAX BASE* (MARKET VALUE OF REAL ESTATE)
IS RISING FASTER IN THE SUBURBS**
1962
1972
Change
(1962-72)
Pe rcent Change
(1962-72)

Philadelphia
County
$5889.8
7617.0

$1727.2

Bucks Delaware
County
County
$1237.9 $2142.8
2961.2
2474.8

$1236.9

29.3%

99.9%

Montgomer>
County
$2664.5
4708.5

$ 818.4

$2044.0
76.7%

38.2%

*Dollar figures are in millions.
**Chester County is not included because it is not contiguous to Philadelphia County.
SOURCE: Pennsylvania Department of Commerce, Pennsylvania Statistical Abstract.

TABLE 2

BUT SO IS THE POPULATION
1962
1972
Percent Change

Bucks Delaware
County
County
308,567 553,154
415,056 601,425
8.7%
34.5%

Philadelphia
County
2,002,512
1,950,098
-2.6%

Montgomery
County
516,682
623,921
20.8%

SOURCE: U.S. Department of Commerce, Census of Governments— Com ­
pendium of Government Finance, Table 53.

TABLE 3

LEAVING TAX BASE PER PERSON GROWING AT
SIMILAR RATES
1962
1972
Percent Change
(1962-72)

Philadelphia
County
$2941.2
3906.0

32.8%

Bucks Delaware
County
County
$4011.8 $3873.8
5962.6
4923.6

48.6%

SOURCE: Tables 1 and 2.




5

27.1%

Montgomery
County
$5156.9
7546.6

46.3%

BUSINESS REVIEW

JUNE 1975

TABLE 4
E X P E N D I T U R E P ER P E R S O N IS R I S I N G S I G N I F I C A N T L Y F A S T E R
IN P H I L A D E L P H I A T H A N IN S U R R O U N D I N G C O U N T I E S *
P h ila d e lp h ia
C o u n ty

M o n tg o m e ry
C o u n ty
P e rc e n t
1972
Change

1962

1972

P e rc e n t
Change

1972

1 3 8 .2 %

$155

$326

1 1 0 .3 %

$213

$463

1 1 7 .4 %

$432
92
340

1 5 5 .6 %
2 17.2
1 4 2 .9

$145
26
119

$338
96
242

1 3 3 .1 %
2 6 9 .2
1 03.4

$185
44
154

$455
150
305

1 4 5 .9 %
2 4 0 .9
98.1

21%

24% **

18%

28%

5 6 % *•

24%

33%

37% *’

1962

$635

2 0 3 .8 %

$183

$436

$590
216
374

1 8 2 .3 %
5 3 5 .3
1 1 3.7

$169
29
140

37%

E x p e n d it u r e p e r
$209
P e rso n
Revenue per
P e rs o n
$2 09
In t e r g o v e r n m e n t a l
34
O w n S o u rce s
175
In t e r g o v e r n m e n t a l as
16%
P e r c e n t o f T o ta l

B ucks
C o u n ty

1962

1972

1962

D e la w a re
C o u n ty
P e rce n t
Change

P e rc e n t
Change

131% ’ *

17%

'D o l l a r f ig u r e s a re in m illio n s .
• • R e p r e s e n t s ra te o f g r o w t h o f in t e r g o v e r n m e n t a l a s p e r c e n t a g e o f to ta l re v e n u e .
S O U R C E : S a m e as T a b le 2.

TABLE 5
W H IL E T O T A L E X P E N D IT U R E S ARE R IS IN G
O N L Y S L IG H T L Y FASTER

1962
G e n e ra l R eve n u e
In t e r g o v e r n m e n t a l
O w n S o u rce s
Taxes
P ro p e rty
O th e r
D ir e c t G e n e r a l
E x p e n d it u r e s

P h ila d e lp h ia
C o u n ty
P e rc e n t
1972
Change

1962

M o n tgo m e ry
C o u n ty
P e rc e n t
1972
Change

D e la w a re
C o u n ty

B u cks
C o u n ty

1962

1972

P e rc e n t
Change

1962

1972

P e rc e n t
Change

$ 4 1 8 .6
6 7 .8
3 5 0 .9
2 7 9.4
1 62.9
1 16.5

$ 1 15 1 .6
4 2 1 .9
7 2 9.7
5 5 7 .0
2 3 1 .3
3 2 5 .7

1 7 5 .1 %
5 2 2 .3
108.1
9 9 .4
4 2 .0
1 7 9.6

$ 8 7 .4
14.8
72.5
5 8 .5
53.2
5 .5

$ 2 69 .5
5 7 .2
2 1 2 .3
168.1
1 52.6
1 5 .5

2 8 8 .4 %
286.5
1 9 2.8
185.9
1 86.8
1 8 1 .8

$ 80.0
14.2
6 5 .8
5 3 .2
4 9 .4
3 .8

$ 2 03 .8
5 8 .0
1 4 5.8
1 1 8.7
1 11.4
7 .4

1 5 4 .8 %
3 0 8.5
1 2 1.6
123.1
1 2 5.5
9 4 .7

$ 5 7 .0
1 3 .6
4 7 .4
32.1
2 7 .6
4 .5

$ 1 88 .5
6 2 .2
1 2 6.4
9 6 .2
8 4 .8
1 1 .4

2 3 0 .7 %
3 60.3
1 66.7
199.6
2 0 7.2
1 5 3.3

$ 4 17 .6

$ 1 23 7 .9

1 9 6 .4 %

$ 9 4.7

$ 2 7 2 .2

1 8 6 .4 %

$ 8 5.7

$196.1

1 2 8 .8 %

$ 6 5 .6

$ 1 92 .2

1 9 3 .0 %

• D o lla r f ig u r e s a re in m illio n s .
S O U R C E : S a m e as T a b le 2.

ing to a different tax is not likely to alleviate
the problem (see Box 1). City residents pay­
ing more in total local taxes than it costs to
serve them are still likely to have an incentive
to move to the suburbs. It is this incentive
that is at least partially behind the fiscal plight
of many major cities.

services provided by a local community. Res­
idents as voters register their desires through
elections, and the elected representatives
try to coordinate the often conflicting goals
of various groups. Some economists, how­
ever, emphasize a rather different aspect
of this process. They point out that com­
munities can be considered as sellers of a
package of goods and services who charge a
certain tax-price for the package. So while a
resident/voter can try to influence what local
government does, he can also decide to
move to a community more tailored to his

LOCAL INCOME REDISTRIBUTION: AN
INCENTIVE TO MOVE?

Most people consider political factors as
the primary determinants of the tax rates and




6

FEDERAL RESERVE BANK OF PHILADELPHIA

BOX 1

HIGHER RESOURCE COSTS VERSUS INCOME
REDISTRIBUTION
There are, of course, many reasons why a central city might have faster growing
expenditures per capita than do the suburbs. However, most of these phenomena do
not create distortions in the economy. When the higher expenditures and, hence,
higher taxes represent the cost of serving residents, then the movement of residents to
find more services for fewer tax dollars is beneficial to the economy. For example, if
wages and land costs are rising fast in the city and this raises the cost of running local
government, then someone who moves out frees the resources which were used to
provide him with services. This person is made better off and no one is worse off.
However, if taxes are high in order to pay for the services which someone else receives,
then moving out lowers the city's income by more than it lowers expenses. In this
situation, even people who would be willing to pay the cost of service to them may be
driven away. This then raises the tax burden and/or lowers service levels for those
remaining and may lead to the cumulative process discussed in the text.
The same situation arises no matter who is being subsidized. For example, some
people argue that suburbanites directly exploit the central city. They commute in and
impose costs on the local government and then leave without paying any taxes. Partially
in response to this argument, some central cities levy wage or income taxes; however,
there is very little evidence to support this allegation.* To the extent that this does
happen, a wage tax can offset the income redistribution to suburbanites; but if it does
not happen, the wage tax will distort location decisions in favor of suburban jobs. The
discussion in the text is equally applicable to all types of local income redistribution.
*Fora detailed discussion, see “ Suburban Exploitation of Central Cities," by David F. Bradford and Wallace
E. Oates, presented at the Urban Institute conference on “ Economic Policy and the Distribution of Benefits,"
held in Washington, D. C ., March 23-24, 1972.

preferences. Consumers in a sense "shop"
among communities much as they shop
among stores for goods.
Unfortunately, though, this analogy has its
limitations. There are easily recognizable dif­
ferences between the way stores sell and the
way local governments "sell." Stores charge
directly for the items bought while govern­
ments charge indirectly by taxing sources
such as property or income. This difference
affects people when they are "community
shopping."
The major effect is that people do not




necessarily contribute equally to the cost of
public goods and services, even if they re­
ceive the same benefits. For example, with a
property tax, a person with a small house
might pay much less in taxes than a neighbor
with a big house although both may send the
same numberof children to the same school.
This local redistribution of income may be
desirable on equity grounds (if we accept
"ability to pay" as our equity criterion), since
presumably the resident of the larger house
is wealthier. (See Box 2.) However, such a
situation motivates the person paying higher
7

JUNE 1975

BUSINESS REVIEW

BOX 2

EQUITY, PRODUCTION EFFICIENCY, AND SOCIAL
EFFICIENCY
There are two criteria which appear to be used most in judging governmental
actions— equity and efficiency. Equity relates to "equal treatment." Unfortunately,
this is about all that can be said in this area without provoking some controversy.
Does it relate to equal treatment of equals or equal treatment of everyone? Should
the poor get the same as the rich, or more, or less?* Government is often in the
position to provide different levels of services to different groups or to charge them
different taxes. When government actions in this regard favor the poor, there is
essentially a transfer of income. This transfer of income is carried out for equity
purposes. Thus, one goal of government could be to promote equity through income
redistribution.
Efficiency can be broken down into production versus social efficiency. We can look
at production efficiency as being the least costly production of a given good or service
and social efficiency as being the production of goods and services most desired by
consumers. For example, a firm may be a very efficient producer of buggy whips in terms
of keeping the cost per whip down, but it may be wasting resources because no one
wants buggy whips. This would be a case of production efficiency which is not social
efficiency. In a competitive economy, such a firm would go out of business; however,
government subsidies might allow it to remain in operation. Similarly, other firms in
some noncompetitive positions may be producing desirable goods but in a very costly
manner. As long as the goods are worth more than the resources used in producing
them and they would not otherwise be produced, then it may be socially efficient to
provide them although we don't have productive efficiency. Thus, productive efficiency
and social efficiency are two other possible goals of government.

*For a treatment of some of the issues, see Anita A. Summers, "Equity in School Financing: The Courts
Move In," Business Review of the Federal Reserve Bank of Philadelphia, March 1973, pp. 3-13.

which each resident of a community has ap­
proximately the same amount of property
and makes similar tax payments.5All persons
who want smaller houses or apartments
would be kept out by zoning laws or similar
arrangements.

taxes to try isolating himself from the person
paying lower taxes, since the wealthier resi­
dent is, in a sense, paying part of the poorer
person's bill. Each person has an incentive to
live in a community in which he has less
property (and hence lower tax payments)
than anyone else in the community. Of
course, everyone cannot have less than the
average amount. The only stable solution to
this type of system would seem to be one in




5Renters are assumed to pay property taxes through
their rent payments.
8

FEDERAL RESERVE BANK OF PHILADELPHIA

Redistribution and Efficiency. Economics
tells us that if the price of something corre­
sponds to the costs of providing it, then our
scarce resources will be channeled to their
most highly valued uses. When local gov­
ernments charge tax “ prices" unrelated to
the costs of the services they provide, these
resources may end up in inefficient uses. For
example, consider our friend Smith's deci­
sion to move from the city to the suburbs.
Suppose he was entirely happy with the ser­
vices he received but discovered the same
services could be received in suburbia for
lower taxes. If the cost were the same in the
two places, but taxes were higher because of
local income redistribution, then Smith's
move would waste both the resources in­
volved in the actual move and those used in
his daily commuting. However, if taxes were
different because the suburban government
had lower costs, then Smith's move would
result in the saving of resources employed in
providing the services. This saving would be
balanced against the cost of Smith's moving
and commuting. In this case moving would
mean not only a cost saving to him, but more
efficient use of society's resources would re­
sult (Box 2).
If suburban communities succeed in keep­
ing out low-income residents, they reduce
the incentive for current suburbanites to
move around. This can cut the loss of re­
sources resulting from a game of "musical
chairs" among communities. However, this
cannot reduce the loss of resources because
of excess movements out of the city, and it
reinforces the result of little or no income
redistribution at the local level.
This description of how people choose a
community may seem an extreme case, and
it certainly omits other important factors
which shape a location decision. However,
tax-benefit considerations may have signifi­
cantly influenced the movement to suburbia
and may have helped create communities
where all the residents have very similar
characteristics. To the extent that this pro­
cess really operates, it can thwart the attempt




of cities to pay for the services they provide
by redistributing income through taxes. In
fact, attempts to redistribute income locally
through taxes can not only influence the
movement of people and jobs out of the city,
but can also backfire and deepen the plight of
the poor.
Redistribution and Low-Income Residents. If
attempts to redistribute income lead to sep­
aration of families by income class, then the
poor could be worse off than if no income
redistribution were attempted. This is be­
cause current financing only allows com­
munities with a large tax base per person to
provide large amounts of goods and services
per person. Thus, it is usually necessary for
each resident of such a community to buy a
large house or rent an expensive apartment.
A poor family desiring high levels of some
public services (education, for example)
would then have to pay for large amounts of
housing as well as for the services they de­
sire. While low-income families might be
able to afford payments for the services, they
obviously cannot also afford large payments
for housing. Efforts to encourage lowincome housing in the suburbs have encoun­
tered stiff opposition, with income redis­
tribution probably a major objection. The
likely outcome is that the poor with their
demand for services are "locked" into the
central city. And, there's the heart of a "fiscal
crisis."
So, cities face the problem of providing
goods and services which are increasingly
more costly to a population which has a grow­
ing percentage of those with the least ability
to pay. This leads to high-tax and low-service
levels for those who can pay. To avoid in­
come redistribution payments at the local
level, some people who would otherwise
have stayed in the city may incur the costs of
moving and commuting. They might also
move to a community which provides a dif­
ferent amount of public services than they
would choose if they were bearing the direct
cost.
9

JUNE 1975

BUSINESS REVIEW

The net result is likely to be some waste of
society's resources, very little actual income
redistribution at the local level, and forces
continuing to militate against locating in the
central city. While there are many factors
creating fiscal pressure on the city, this
one may truly be called a “ fiscal crisis/' for
the situation cannot be controlled from
within the city. However, this does not imply
that all cries of “crisis" should be treated the
same. If the city is driving away jobs and resi­
dents because it has high production costs or
is inefficient, the situation should be labeled
an internal management problem, not a
crisis.

that to some extent it forces people to reveal
what they are willing to pay for government
services. Suppose property taxes were used
only to finance goods and services whose
costs are approximately proportional to the
amount of property people own. It is then
likely that the “shopping" element of com­
munity choice would direct people with simi­
lar preferences for government services to
the same communities. They would not have
any incentive to move to communities that
provided more of these services than they
wanted because they would have to pay the
cost. Similarly, people would not have an
incentive to move to communities providing
too little of these services because the resul­
tant tax savings would not compensate them
for having less of these services.
The second benefit (and perhaps that
which advocates of local government stress
most) is the wider range of choice which re­
sults from many “suppliers" (governmental
units). For example, suppose that Jones
would like more police protection than
would Smith. If they live in the same com­
munity, both cannot be satisfied. Voting may
lead to some compromise, perhaps less than
Jones would like to “ purchase," but more
than Smith wants to pay for. However, if
Jones and Smith each move to other com­
munities populated with residents of similar
tastes, each may be able to achieve his de­
sired level of police protection. A more inclu­
sive metropolitan government is not likely to
offer as much variety.
This is not meant to imply that local gov­
ernment would not have fiscal pressures in
the absence of local income redistribution.
Most economists now agree that suburbani­
zation would have occurred even if central
cities had had no fiscal or social problems.7
Also, people in every community will want to

PROPOSED SOLUTIONS

Two often-proposed methods of aiding the
central city are the formation of a metropoli­
tan or regional government and the sharing
of revenue by the state or Federal Govern­
ment. Either method can achieve the goal of
relieving the fiscal pressure on central cities,
but each also has shortcomings.
Metropolitan Government: A Loss of Com­
petition. A metropolitan government consists
of a central city and all of its suburbs replac­
ing many local governments. Proponents of
this approach argue that it would eliminate
competition for the tax base at the local
level.6 Individuals or businesses would have
to move outside the metropolitan area to es­
cape paying their share of taxes. The problem
with this solution is that local government
competition can be desirable.
Local government, locally financed, is ben­
eficial in two important respects. The first is

6There are a number of arguments related to coor­
dinating the actions of local governments which are also
expounded by proponents but which will not be covered
he re. For a discussion of these arguments and alternative
forms of metropolitan government, see L. Christine
Grad, "Blueprint for Metropolitan Reform," Business
Review of the Federal Reserve Bank of Philadelphia, O c­
tober 1971, pp.12-17.




7For example, see Edwin S. Mills and James MacKin­
non, "Notesonthe NewUrban Economics," Bell Journal
of Economics and Management Science 4 (1973): 593601, 596.
10

FEDERAL RESERVE BANK OF PHILADELPHIA

munity which can best satisfy their prefer­
ences with the least use of resources.

minimize their costs for particular services.
But this type of incentive serves to inform
government of what the residents want. In
this case, a community may lose residents by
not providing the desired level of services or
by being inefficient, but it will not lose resi­
dents because another community is a "tax
haven."

LOCAL FINANCING WITHOUT
INCENTIVES TO MOVE

It may sound like local tax financing will
always create incentives for people to sepa­
rate into similar income groups, but this is
not true. This result arises from attempts to
redistribute income locally through the tax
process. If Smith's taxes represent the cost of
serving him, then it doesn't matter much to
the community whether or not he lives there.
Neither a new rich neighbor nor a new poor
one would alter the taxes or benefits for cur­
rent residents of the community. For exam­
ple, if the property tax were restricted to
financing services whose cost is approxi­
mately proportional to the amounts of prop­
erty in the community just as the property tax
is, then people with large houses would have
no tax incentive to bar construction of small
houses. Such services as fire protection are
likely to fit into this category. Thus, owners of
large houses on large lots (which are likely to
require more fire equipment and create a
bigger area to cover than do small houses on
small lots) would pay higher taxes to offset
the higher costs imposed on the community.
No doubt there are other reasons why people
might want similar houses in the same com­
munity (such as aesthetic appeal and a desire
to socialize with people of similar income),
but such considerations often relate more to
an immediate neighborhood than to an en­
tire town.
When a government service has costs
which are not related to property, then the
property tax should not be used for financ­
ing. Similarly, if the cost of serving someone
is not related to his income, then a local in­
come tax should not be used to finance that
service. Certainly, we would seldom expect
to find an exact correspondence between a
certain tax and the cost of providing a particu­
lar service. But now taxes and services are
usually completely unrelated. Take welfare

Sharing Revenue Distorts "Prices." The shar­
ing revenues approach leaves government
units unchanged but provides funds from
state or Federal sources to relieve the fiscal
pressure on local government. Tax collec­
tions are made from all over the state or even
the country, making tax avoidance very
difficult.
Sharing revenue has been with us for
some time, although large-scale transfers of
unconditional funds are relatively recent oc­
currences. Table 5 shows that funds from the
state and Federal governments have been
growing faster for Philadelphia than for any
of its neighboring Pennsylvania counties. In
fact, while Philadelphia had the largest per­
centage increase in expenditures, the growth
of transfer funds has been sufficient to give it
the smallest percentage increase in taxes and
in total revenue from local sources. Thus,
sharing revenue has, indeed, relieved some
of the fiscal pressure on central cities and
other local governments. However, this solu­
tion also has a drawback.
Revenue sharing does not force people to
relate their tax payments to the cost of pro­
viding services. If one community should
consistently get more in transfer funds than
another, it will become more attractive rela­
tive to the second community. In addition,
each community will still have incentives to
attract businesses and individuals who pay
more in taxes than it costs to serve them and
to keep others out. Because the "prices" of
services in one community versus another
still do not reflect the cost of resources used
in providing these services, people will ex­
pend time and money in relocating.
Moreover, they will not move to the com­




11

JUNE 1975

BUSINESS REVIEW

Let the state and Federal governments fi­
nance services which entail significant in­
come redistribution. Income redistribution
can be more effectively administered atthese
higher levels of government. The difficulty
in avoiding broader-based taxes will reduce
the amount of resources spent in trying to
avoid them. At the same time, the benefits of
local choice can be maintained or increased.

as an example. Most people agree that soci­
ety has some obligation to care for the indi­
gent, but why should the burden fall on
property owners in a particular community?
This is definitely an area where direct pay­
ments from the Federal Government would
lead to more equal treatment for the poor in
different communities and would relieve an
unfair burden on city property owners. This
proposal would, in turn, reduce the incentive
to move strictly to avoid local tax payments
aimed at redistributing income.
Another benefit of such a system is that the
range of choices available to many people
would increase. Education is a good exam­
ple. "Charging" on the basis of the number
of schoolchildren avoids income redistribu­
tion at the local level. Given that government
has assumed the financing of the service, the
funds should come from state or Federal
sources. One way would be for the state to
issue a voucher which would be used to
"pay" for schooling.8 Each student would re­
ceive a voucher and present it to the school
he attends. The school would then redeem
the voucher with the state or Federal gov­
ernment for its operating funds. Local com­
munities might continue to provide school
services, but there would no longer be any
reason to restrict entrance to local residents.
Thus, a family would not have to relocate to
obtain the educational services it desires.
In short, let local government continue to
finance those services which do not result
in significant income redistribution. And,
whenever possible do this with taxes that
closely reflect the costs of providing services.

SUMMING UP

Now, what about that "fiscal crisis"? To the
extent that such a crisis exists, it is at least
partly caused by communities using local
taxes to finance public goods and services in
such a way that some redistribution of in­
come results. When this effect is large, com­
munities are forced both to compete for citi­
zens who make a net contribution to the local
treasury and to keep out those who are a net
drain. This can lead to segregation by in­
come, and it's possible for this to make
everyone, including the poor, worse off than
if no such attempt were made.
The benefits of many communities offering
a range of services are very real. Financing
the wrong services — ones where taxes are
not linked to costs— by means of local taxes
is likely to cause inefficient use of resources
and excessive decentralization of people and
businesses. It is time for a rational approach
to financing government expenditures, and
this includes a recognition that efficiency and
equity may require one level of government
to raise taxes while another provides goods
or services. However, it also requires the
recognition that competition at the local level
can be beneficial. There is no reason for city
governments to be spared from having to
accept the tradeoff of taxes and services
faced by other governments. But there is also
no reason for them to shoulder most of the
burden of financing services for the poor.
K

8
The voucher plan allows parents to determine what
school to send their children to while having the state
continue to finance the education. See David W. Lyon,
“ Capitalism in the Classroom: Education Vouchers,"
Business Review of the Federal Reserve Bank of
Philadelphia, December 1971, pp. 3-10.




12

I

R isin g
M ed ical C are
E xp en d itu res •
•
a g ro w in g role fo r
th e public secto r




BUSINESS REVIEW

CHART 1

CHART 2

HEALTH CARE EXPENDITURES ARE BE­
COMING AN INCREASING SHARE OF
OUR GNP.

ONE REASON FOR THIS INCREASE IS
THE RELATIVELY RAPID RISE IN THE
COST OF MEDICAL CARE.

Percent

Percent
Percent Changes, Consumer Price
Indices
1960-74

SOURCES: U. S. Department of Health, Edu­
cation and Welfare, Social Security Adminis­
tration, Social Security Bulletin; Economic
Report of the President.




14

FEDERAL RESERVE BANK OF PHILADELPHIA

CHART 3

CHART 4

IN ADDITION, BOTH THE QUALITY AND
THE QUANTITY OF THE SERVICES PRO­
VIDED HAVE INCREASED, LEADING TO
AN INCREASE IN REAL PER CAPITA EX­
PENDITURES ON MEDICAL SERVICES.

HOWEVER, THE PUBLIC SECTOR* IS
FINANCING A GROWING SHARE OF ALL
MEDICAL PAYMENTS.

Dollars (1967)




Percent

* Public sector includes Federal, state, and
local governments.

T5

BUSINESS REVIEW

On December 31, 1974, Americans were permitted to buy and sell gold for the first
time in some 40 years. Since then questions have been raised about the once-hallowed,
almighty metal's worth and importance. For example, has its status in the United States
and in the international monetary system changed? If so, in what manner? A pamphlet
recently produced by the Philadelphia Fed's Department of Public Information con­
siders the role of gold— past, present, future.
Copies are available free of charge. Please address all requests to Public Services,
Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105.




Restrictive Labor
Practices in Baseball:
Time for a Change?
By Janice M. Westerfield

have exempted them from antitrust action.
They argue that while an ordinary business is
untroubled if it wipes out its competitors, a
professional baseball team is in jeopardy if
the financially weaker teams fail. The reason
is that even the stronger teams need a league
in order to operate profitably. Thus, while it's
desirable to compete as hard as possible on
the playing field, it's unwise for teams to
compete against each other in a business
manner, say the owners.
Team owners contend that baseball's re­
strictions on the labor market can be justified
on other grounds as well. Their major con­
tention is that the player reservation system
equalizes team playing strengths and this is in
the "public interest." Otherwise, the richer
teams would garnerthe bulkof playingtalent
and lopsided games would result. Team
owners also suggest that these noncompeti­

When pitcher Jim (Catfish) Hunter was de­
clared a free agent last December, he enter­
tained offers from 23 of the 24 major league
teams in the hottest bidding war in baseball
history. He finally signed a five-year contract
with the New York Yankees for a record $3.75
million. Never before had an experienced
player of Hunter's caliber— he pitched the
Oakland A's to three consecutive World
Series Championships and is considered by
many experts to be baseball's top pitcher—
enjoyed free-agent status.
Competitive bidding for Hunter's services
spotlighted one of professional baseball's
unique labor practices— the player reserva­
tion system which can keep a player from
selling his skills to the highest bidder. Sports
entrepreneurs defend the noncompetitive
labor practices by claiming that professional
teams are unique and note that the courts




17

BUSINESS REVIEW

JUNE 1975

tive practices help "maintain the integrity of
the game" by assuring fans that players are
loyal to their team. Finally, by preventing
bidding wars (except in unusual cir­
cumstances), the weaker teams have greater
financial security.
After Catfish Hunter declined the Philadel­
phia Phillies' offer of $2.6 million, Phillies
President Ruly Carpenter said the rejection
underscored the need for retaining the "re­
serve clause" in baseball. Does it? Or do the
terms of the contract simply show the extent
to which Hunter was previously paid less
than his value to the team? An economic ap­
proach provides a much-needed dimension
to the debate on the player reservation sys­
tem and helps sports fans make some sense
out of the industry's chaotic business condi­
tions. In other words, who gains what under
the current setup?
THE RESERVE CLAUSE

titrust action has encouraged collusion
among the teams, allowing them to draw up
explicit business rules for the conduct of the
sport. (For more on baseball structure, see
Box 1.) Perhaps the most important set of
rules in baseball concerns the player reserva­
tion system. This system includes rules gov­
erning the acquisition of new players, the
promotion of players from minor to major
leagues, and movement of players from one
major league team to another.
Specifically, the reserve clause in each
player's contract gives a team the exclusive
right to buy the player's services for the next
season. In practice, it often ties a player to a
team for his entire career, because under a
reserve clause exclusive rights are retained
by the team whether the athlete plays or not.
A player may be transferred from one team to
another only if the team owning his services
releases him from his contract or allows
another team to buy his contract and
negotiate with him.

Organized baseball's exemption from an­

BOX 1

THE ECONOMICS OF BASEBALL STRUCTURE
Organized baseball acts like a "cartel." It restricts competition in business practices,
regulates entry, and divides markets among teams in the two major leagues and several
minor leagues. The antitrust exemption has encouraged teams to collude and to set up
explicit business rules which are codified and open to public scrutiny. Output is limited
by restricting the number of league franchises and the location of the teams. The
establishment of territorial rights for each team prevents expansion teams from raiding
another team's home territory. In addition to receiving income from admissions and
concessions, teams benefit from the sale of radio and TV rights. Here again, rules limit
competition in selling the industry's product. Leagues control the right to national
broadcasts and each team holds exclusive rights to broadcast locally all home games
that are not part of the league's national package. Professional baseball also has a com­
plex set of rules dealing with interteam competition for players, the industry's most
important production input. The rules governing the acquisition of new and veteran
players are at the heart of the dispute on sports business practices.
In a cartel, cooperative behavior among the teams will assure greater profits than a
competitive system. Yet, a particular team may increase its profits if it can convince all
other teams to abide by the rules of the cartel and then itself cheat on the regulations.




18

FEDERAL RESERVE BANK OF PHILADELPHIA

BOX 1 (Continued)

For instance, a team could benefit by negotiating with players on other teams as long as
the other teams do not reciprocate. To prevent secret negotiations with individual
players, baseball has a "no-tampering" rule against bargaining with a player whose
contract is owned by another team. Such rules, which are difficult to enforce, require
serious penalties to dissuade member teams from violating them.
Organized baseball displays another cartel feature— a lack of innovation. Changes on
most matters require a three-quarters majority vote in the league. Thus, on issues
affecting both leagues, a mere four teams can thwart a change in major league rules. The
voting rules make it difficult for organized baseball to respond to opportunities for
profitable innovation. Critics claim the lack of innovation partially accounts for
baseball's inability to keep its share of the total sports dollar.
Perhaps because the cartel has been slow to adjust to external changes eroding
profitability, the sketchy financial data available indicates that few baseball teams are big
moneymakers. The Los Angeles Dodgers and the New York Mets are probably the most
profitable; they are located in large metropolitan areas and draw around two million
fans apiece. In the American League the Baltimore Orioles, winner of the World Series
in 1970, earned only $345,000 after taxes that year on revenues of $4.6 million— and their
profit figure was believed to be the highest in the league. In 1970, a survey revealed that
only half of the major league baseball teams netted an after-tax profit or broke even.*
However, because of the special tax advantages of sports enterprises, such as depreciat­
ing the value of player contracts, baseball teams may actually be more profitable than
the accounting figures would suggest.** Current profit figures also ignore capital gains
resulting from increases in the value of the franchise.

*"Who Says Baseball Is Like Ballet?" Forbes, April 1, 1971, p. 30.
**Tax shelters traditionally open to sports enterprises may be threatened by a U.S. District Court ruling last
February against the Atlanta Falcons. The Court reduced the allowable depreciation reductions on football
player contracts and ruled that TV rights could not be depreciated. The uncertainty of tax advantages from
depreciation may reduce the market value of pro sports franchises.

The player reservation system is intended
to limit competition among teams for the ser­
vices of players. The agreement not to com­
pete is the key to the reserve clause's effec­
tive operation. If a particular team tries to
negotiate with a player to see if he is inter­
ested in changing teams, it runs the risk of
being severely penalized. By restricting the
right of a player to negotiate with another
team while under contract to his current
team, the "no-tampering" rule deprives the




player of his freedom to choose his prospec­
tive employer or place of employment. The
officially stated reason for the reserve rule is
that it "inhibits the moneyed clubs from ac­
quiring all of the best talent."1 Supporters
contend that the reserve clause does tend
to equalize the strengths of the poor and
'U.S., Congress, House, Committee on the Judiciary,
Subcommittee on Study of Monopoly Power, Organized
Baseball, 82d Cong., 2d sess., 1952, p. 105.
19

BUSINESS REVIEW

JUNE 1975

Veteran Player Draft. Although a major
league baseball team is limited to carrying
about 25 players on its active roster, it may
have up to 15 more players under exclusive
contract. These "protected" athletes play for
minor league teams affiliated with the parent
club. Players not on the protected roster of
major league teams may be reallocated by
means of a veteran player draft at the end of
each season. This draft attempts to equalize
playing strengths by limiting direct competi­
tion for the player. First, teams draft players
in reverse order of standings for a stipulated
amount, currently set at $25,000. This means
a team cannot bid for a player's services by
promising a higher salary or offering to place
him on its protected roster. Second, the
drafted player must be placed under exclu­
sive contract, thereby releasing one of the
protected players and making him eligible to
be drafted by other teams. Like the draft,
limits on the number of protected players are
alleged to equalize team strengths. Team
owners argue that, otherwise, championship
teams would keep too many players under
exclusive contract, thereby depriving lowerranked teams of playing talent.

the rich teams. This rule is also said to en­
sure the honesty of the game by bolstering
public confidence that players are competing
to win. It is feared that a player negotiating
with another team would lack the "winning
spirit"— this could raise suspicions of a fix if
he muffed an easy play.
DRAFTING
New Player Draft. Central to the player res­
ervation system is the new player draft. This
draft was established in 1965 when the
baseball cartel realized that bonuses to
amateur players were costing teams big
money. Here's how it works. The names of
the eligible amateur players are pooled and
the teams draft the negotiation rights in re­
verse order of the won-lost standings. The
lowest-ranking team then gets first pick of
the new player draftees. The new player and
the team that has drafted him have six
months to negotiate a contract. During this
period, the player may not negotiate or
make a deal with any other team. If the
player and the drafting team cannot reach
an agreement, then the player returns to
the pool to be drafted by a second team in
the "secondary phase" of the draft. The sixmonth bargaining period in baseball puts the
player in a slightly better negotiating position
than in football where if a player cannot con­
clude a contract with the assigned team, he
has no alternate means for reaching an agreement to play for another team. The limit­
ed time period in baseball also gives some
encouragement for a team to offer a signing
bonus.
The arguments advanced for the new
player draft are essentially those given for the
reserve clause. The primary purpose was to
end the competitive bidding through bo­
nuses which were transferring wealth from
the club to the players. By drafting in the
reverse order of standing, it was also argued
that the weaker teams would benefit rela­
tively more than the stronger ones.




"Waiver Rule." Sales of player contracts are
also limited by the "waiver rule." A team
wishing to sell a player's contract must "clear
waivers"— that is, each team in the league
must have the opportunity to buy, at a fixed
price, the exclusive rights to bargain with the
player. Acquisition rights for waivered
players are tendered in reverse order of team
standing. In baseball, even after a player is
waived, he may not be free to negotiate with
teams in the other league. The waiver rule is
another means of restricting competition for
veteran players.
THE RESERVATION SYSTEM: WHO BENEFITS,
WHO DOESN'T?

Economic logic and statistical studies say a
great deal about the alleged benefits of the
20

FEDERAL RESERVE BANK OF PHILADELPHIA

topflight player and see him play for another
team.2
*
Supporters of the reserve system may
counter that team owners may receive
psychic satisfaction from hoarding expert
players. Hence, the current setup is required
to prevent unequal distributions of talent.
Economists retort that the reserve clause and
player drafts are unequal to this task. The
reason is that resources tend to move toward
their most highly valued uses (given welldefined property rights and small costs of
exchange). The player reservation system
fails to prevent player transfers from one
team to another for cash or other players. If a
player's services are worth most to the team
having exclusive rights to his contract, then
no other team will want to pay the current
owners enough to bid him away. But, if the
player's services are valued more highly by
another team, and if the costs of transferring
the player's contract are small, the team that
values him most will bid the contract away
from the current owners. Thus, each player
will play for the team which gets the highest
return from his service— the same as in most
other professions operating in a free market.
Player sales and trades also probably offset
any equalizing effects that the new and veter­
an player drafts have on team strengths.

player reservation system. First of all,
economic theory suggests that artificial
mechanisms designed to promote equal
playing strengths among teams are unneces­
sary. Indeed, it runs against the economic
interests of a team to become overloaded
with star players. Second, even if equalizing
team strengths were desirable (perhaps be­
cause team owners don't behave as econom­
ic logic would predict), the player reservation
system fails to perform this task. The reason
is that it doesn't prevent the most talented
players from being transferred from one
team to another.
The player reservation system does have
some economic effects, however. It in­
creases the financial security of team owners,
for example. It does so principally by keeping
player salaries lower than they would other­
wise be. Financial losses to the players are
considerable. Lower salaries mean that pro­
spective players devote less time and energy
to developing batting and fielding skills. The
overall level of individual team quality is
lower as a result.
Playing Strengths. In their support of the
player reservation system, team owners view
the necessity of a mechanism for equalizing
playing strengths as axiomatic. Economic
theory, however, suggests it's highly unlikely
that the financially strong teams would buy
up all the star players if released from the
reserve clause. Any team that tries to buy up
the most capable players will reach a point
where it will forego the services of an addi­
tional talented player. This happens because
a team has an incentive to win by a close
margin rather than by clobbering its oppo­
nents. Close contests with an element of un­
certainty are considered more exciting and
more likely to attract fans. If lopsided sports
contests discourage attendance, it will not be
in the best economic interests of a strong
team to buy up all the talent in the league. At
some point, therefore, a strong team will be
willing to pass up the services of another




2A rich team will not purchase an unlimited number of
talented players. This point is well explained by Simon
Rottenberg in his classic article, "The Baseball Players'
Labor Market," Journal of Political Economy 64 (1956):
301. "Beyond some point— say, when a team already has
three .350 hitters— it will not pay to employ another .350
hitter. If a team goes on increasing the quantity of the
factor, players, by hiring additional stars, it will find
that the total output— that is, admission receipts— of
the combined firms (and, therefore, of its own) will rise
at a less rapid rate and finally will fall absolutely. At some
point, therefore, a first star player is worth more to
poorTeam Bthan, say, athird starto richTeam A. Atthis
point, B is in a position to bid players away from A in the
market. A's behavior is not a function of its bank balance.
It does what it calculates it is worthwhile to do; and the
time comes when, in pursuing the strategy of its own
gains, it is worthwhile, whatever the size of its cash
balance, to forego the services of an expert player and
see him employed by another team."
21

BUSINESS REVIEW

JUNE 1975

Thus, in theory, the distribution of playing
talent between rich and poor teams is not
affected by the reserve clause.3
In practice, even if a player reservation
system is in effect, imbalances between weak
and strong teams persist. The reserve rule
has not frustrated those teams willing to out­
bid others for players. Franchises in areas
with high drawing-potential (usually big
cities) have a stronger economic base and are
apt to develop stronger teams than fran­
chises in low population areas. A look at the
evidence indicates that teams in high draw­
ing-potential areas win more than their share
of championships. If team strength is mea­
sured by pennants won, from about 1900 to
1970 the four largest cities in the American
League won 49 out of 68 pennants while the
four largest cities in the National League won
41 out of 70.4These big city teams tend to bid
some star players away from the low
drawing-potential teams, which are usually
based in smaller cities that generate lower
"live gate" and TV revenues for the home
team.
The limited evidence available also
suggests that the distribution of playing tal­
ent is probably much the same with or with-

out a player reservation system. A recent
study was made of three four-year periods,
beginning with the years 1876-79 before the
reserve clause became operative in 1880 on a
partial basis. During both of the successive
four-year test periods, the reserve clause was
extended to more and more players, yet the
study uncovered no significant differences in
talent distribution for the three periods.5The
quality of the teams was measured by such
factors as the number of years thatteams won
successive championships and the average
percentage of games won (won-lost record)
by a championship team. Similarly, more re­
cent data for baseball, football, basketball,
and hockey show no consistent relationship
between talent distribution measures and
the presence or absence of a free-agent
draft.6

Conversely, if the player is currently playing for
the Phillies, both teams will benefit by transferring the
contract to the Braves at any price between $75,000 and
$100,000. At any price over $75,000, the Phillies will
benefit from the sale of the contract while the Braves will
be willing to pay as much as $100,000.

Financial Security. Although the player res­
ervation system doesn't appear to equalize
playing talent among the rich and poor
teams, owners of the poorer teams do re­
ceive greater financial security. First of all,
the reserve clause reduces their labor costs
compared to competitive bidding. Secondly,
it assures financially weaker teams exclusive
rights to an asset that can be sold to richer
teams. Thus, by financially aiding teams in
less populous markets, the league becomes
more viable.
Similarly, the new player draft is a subsidy
of sorts to the weaker franchises. Since the
teams draft in reverse order of standings, the
weaker teams get preferential treatment.
Likewise, the veteran player draft redistrib­
utes income toward the financially weaker
teams. These teams purchase players from
the powerhouse teams at a below openmarket price; thus, the drafting teams gain
wealth equal to the excess of the market price
over the draft price. The rich teams appar­
ently think it worth their while to support

“James Quirk and Mohamed El Hodiri, "The Economic
Theory of a Professional Sports League," in Roger G.
Noll, ed., Government and the Sports Business
(Washington: The Brookings Institution, 1974), p. 48.

5Michael E. Canes, "The Social Benefits of Restrictions
on Team Quality," in Noll, op. cit., p. 85.
6lbid., p. 88.

3Under a reserve clause, a player will theoretically be
transferred to the team for which he generates the most
revenues. For example, suppose a player is worth
$75,000 to the Philadelphia Phillies and $100,000 to the
Atlanta Braves, and his contract is currently held by At­
lanta. The Phillies will be willing to pay a maximum of
$75,000 (and probably less if they hope to gain revenues
by paying the player less than his value to the team).
However, as long as the Braves are willing to top that
figure, the player will remain on their roster.




22

FEDERAL RESERVE BANK OF PHILADELPHIA

the league by bearing a larger share of the
financial burden. Of course, the player res­
ervation system is only one of many
schemes which could be employed to redis­
tribute income among league members. For
example, a change in the way gate receipts
are shared could also affect a redistribution
of income.

One study that estimated the extent of the
wages lost under the reserve clause for three
qualities of players found that baseball
players suffer a financial loss of "considera­
ble magnitude."7 Over their playing careers,
average players are paid about 20 percent of
the net revenues they generate for the team.
(Net revenues remain aftertrainingand other
costs have been subtracted.) Star players are
paid about 15 percent of the net revenues
they generate. Ironically, only mediocre
players are paid more than the revenues they
generate over their shorter playing careers.

Player Salaries. While the owners of the
poor teams may receive some benefits rela­
tive to the rich teams, the limitations to labor
mobility inherent in the player reservation
system clearly reduce the financial return to
the player. In fact, the redistribution of in­
come from the players to the owners is the
primary economic effect of the player reserva­
tion system. The player can only negotiate
with the team holding exclusive rights to his
contract; he cannot choose from among sev­
eral bids in a free labor market where he
would be paid his full value to the team.
Thus, a differential can exist between the
player's salary and his "worth" to the team.
The cash sale of players from one team to
another suggests that players receive less
than they would under a competitive bidding
system. The player reservation system simply
gives the money acquired in exchange to the
team owners instead of to the player.
The redistribution of income from players
to owners leads to several secondary effects.
First, lifetime player earnings are less. Not
only is the player's salary lower in his first
contract than it would be under competitive
bidding, but he cannot expect to make up the
current shortfall atanytime during his playing
career. Before the free-agent draft, when big
bonuses were common in the competitive
bidding for new players, the bonus would at
most equal the value today of the wages lost
in the future as a result of the player reserva­
tion system. Thus, the player did not suffer
reduced lifetime earnings. With the institu­
tion of the new player draft in 1965, direct
price competition was restricted in the mar­
ket for amateurs and bonuses fell con­
siderably.




Team Quality. Since the restrictive rules in
the baseball labor market reduce player
salaries, skill levels and team quality are re­
duced over the longer haul. Amateur players
can be expected to devote less effort to bet­
tering their skills if they face lower potential
earnings. Since prospective players are free
to choose alternative earning possibilities,
lower player salaries will also reduce the
quantity of baseball talent supplied, and
those amateur players who actually do be­
come professionals will have invested less
resources to sharpen their natural skills.8
Thus, the fans as well as the players suffer
under the current setup.9

7
Gerald W. Scully, "Pay and Performance in Major
League Baseball," American Economic Review 64 (1974):
929.
8Disagreement exists over whether society benefits
from higher average skill levels and higher salaries for
baseball players. For instance, a player paid a free market
salary may feel his income has increased enough for him
to substitute some leisure time for time spent in his
playing career. Also, if star players receive huge salaries,
amateurs are encouraged to devote more effort to sharp­
ening their skills. For those who don't make it, some
people think the effort is wasted.
9An argument can be made, however, that a competi­
tive system promotes too high a level of team quality
because it does not account for external factors which
affect other teams in the league. For a further explana­
tion, see Canes, op. cit., p. 94.
23

BUSINESS REVIEW

MODIFYING
SYSTEM

JUNE 1975

THE

PLAYER RESERVATION

would benefit several teams by making them
more financially viable. Similarly, a team's
monopoly on local broadcasting revenues in
its home territory— the visiting team does
not receive a share of the revenues from local
broadcasts— could be modified to divide in­
come more evenly with the same effects.
If owners as a group can realize the finan­
cial benefits of the reservation system in
some other way, modification of these labor
practices should be easier to accomplish.
One suggestion is to combine the reserve
clause with some kind of an option clause. In
football, an athlete who plays out his option
takes a 10 percent pay cut from his previous
year's salary (which may amount to a higher
percent cut of what he would have earned if
he were a good player). He remains with the
same team for the current season and then is
a free agent who can negotiate with any other
team in the league. A fairly liberal option rule
in baseball could go a long way toward rem­
edying the restrictive employment choices
and the reduced lifetime earnings for the
player offered by the reserve clause.
U.S. Senate hearings on the proposed bas­
ketball merger in 1972 resulted in several
conditions which had to be met to obtain an
antitrust exemption. Some of these could be
suggested to the player association for col­
lective bargaining in baseball. The proposed
bill (which eventually died) provided that
veteran player contracts were to have a
negotiable duration, after which the player
was free to switch teams. This proposal goes
one step further than the option clause by
eliminating it altogether. Another proposal
would retain the amateur draft but obligate
the rookie to play for the team that drafted
him for at least two years, then free him to
negotiate with any team. Both these mea­
sures would increase player mobility and free
employment choice.
Federal legislation may well modify the
player reservation system. In 1972, legislation
was introduced in Congress to establish a
Federal commission to regulate drafting pro­
cedures and other labor practices involving

Supporters of the player reservation sys­
tem claim that it equalizes team strengths.
But economic logic and evidence indicate
that the system hardly affects the distribution
of playing talent. So, the primary benefit of
restrictive labor practices in baseball may
well be a fiction. At the same time, the player
reservation system imposes heavy costs on
the players in terms of lower wages and re­
duced employment choice. Thus, it may be
worthwhile to consider alternative ways to
achieve the secondary benefits of the reserve
system— greater financial security for
weaker teams— so that the reserve clause
can be modified or eliminated. The player
association is already moving against the
player reservation system. Suits have been
filed in the courts to place baseball's restric­
tive labor practices under Federal antitrust
laws. (See Box 2.)
Some alleged benefits of the reserve
clause— more equal playing strengths, great­
er financial gains for the weaker teams —
could be met by dividing income more
equally among the teams. For example, if the
present 80-20 (American League) gate­
sharing arrangement between home and vis­
iting teams were altered to share revenues
more equally (as in football), financial dis­
parities among the teams would be reduced.
Thatway ateam based in asmaller population
area of, say, 1.5 million would receive a larger
proportion of revenues on the road and
would increase its profits even if the team
drew the same number of fans at home. Al­
ternatively, it has been estimated that equal
revenue sharing between home and visiting
teams would reduce the number of fans
needed at home to maintain the same profits,
so that the minimum viable size for a fran­
chise area would be reduced from 1.9 to
1.5 million population.1 An even-gate split
0
10Roger G. Noll, "Attendance and Price Setting," in
Noll, op. cit., p. 131.




24

FEDERAL RESERVE BANK OF PHILADELPHIA

BOX 2

ASSAULTS ON THE RESERVE CLAUSE
AND OTHER RESTRICTIVE LABOR PRACTICES
Baseball has been exempt from antitrust laws ever since Federal Baseball Club v.
National League (1922), when the Baltimore club of the Federal League sued the Amer­
ican and National Leagues for attempting to buyout the members of the Federal League.
The Supreme Court ruled that baseball games were exempt from antitrust because they
were "purely state affairs"; interstate commerce was not the "essential thing." Thus,
baseball was not subject to Federal jurisdiction over interstate commerce and the
Baltimore club was not harmed "by reasons of anything forbidden in the antitrust laws."
Although numerous court challenges have been made to this ruling, it has never been
overturned. When professional football was placed under Federal antitrust laws
(.Radovich v. National Football League), the Court was pressed to make the rulings on
football and baseball consistent and confessed that "were we considering the question
of baseball for the first time upon a clean slate we would have no doubts" about
nonexemption.*
The Court justified the continued exclusion of baseball from antitrust laws by passing
the buck to Congress, which had shown little inclination to bring baseball under these
laws in the preceding years, and concluded that the most appropriate way to redress the
situation (if indeed, redress is called for) is "by legislation and not by court decision."
Congressional reluctance to close the loophole stirred another player, outfielder Curt
Flood, to turn once again to the courts. However, by 1972, the dependence of baseball
structure on the legal precedents proved too difficult to overcome, and Flood lost his
challenge.The majority holding reaffirmed the earlier court rulings, citing the "positive
inaction" of Congress, which "allowed those decisions to stand for so long . . . and has
clearly evinced a desire not to disapprove them legislatively."**
Recently hopes for a reversal were raised from another quarter. Last December a
Federal judge handed down a decision concerning former quarterback Joe Kapp which
could have implications for the reserve systems governing baseball, basketball, and
hockey. The "Rozelle Rule" allows the football commissioner to determine compensa­
tion when an athlete plays out his option — that is, plays one more year at 90 percent of
his previous salary and becomes a free agent— and accepts an offer from another team.
This rule was declared an unreasonable restraint and illegal because by setting a high
indemnity, the commissioner can block a player's employment choice. The decision
also found that the "no-tampering rule," which operates much the same way in football
as in baseball to prohibit players under contract to a team from negotiating with other
teams and to provide penalties for violators, unduly restricts free employment choice. It
*Radovich v. National Football League, 352 U.S. 452 (1957).
**Curtis C. Flood v. Bowie K. Kuhn et at., 407 U.S. at 283-84 (1972).




25

JUNE 1975

BUSINESS REVIEW

BOX 2 (Continued)

is this latter finding which antitrust enthusiasts hope can somehow be broadened to
include baseball.
Meanwhile, assaults on the web of restrictive labor practices are coming from another
Quarter— the player association. Although the Major League Players Association, the
union, represents only players on the roster of the major league teams, it has the poten­
tial to affect labor relations greatly. Collective bargaining has resulted in major gains for
baseball players, notably by allowing them to have a lawyer present when negotiating a
contract. Baseball also has a three-man arbitration board to settle disputes such as that
between Catfish Hunterand Charles O. Finley, ownerof the Oakland A's. One member
represents the players union, a second represents the major league owners, and the
third is an impartial arbitrator. The board gives the players an advantage over the
"one-man rule" policy in football that was found illegal in the Kapp case. Although the
baseball players association has tried to place the player reservation system on the
agenda for collective bargaining, so far the owners have refused to negotiate at all on the
reserve system. However, the 1973 baseball agreement calls for a three-year study of
ways to revise the player reservation system and will serve as a basis for negotiations in
1976.
sales which transfer funds to them at the ex­
pense of the richer teams. However, the fi­
nancial costs to the players are quite high
under the player reservation system. Studies
have shown that players are paid considera­
bly less than the net revenues they generate
for their team. Since playing skills respond
positively to salary increases, lower player
salaries inhibit the amount of prospective
skills produced and result in lower team qual­
ity as well.
Because of the magnitude of the economic
losses suffered by the players, chances are
that the player reservation system will be
modified in the near future, either through
efforts by the player association, through
court suits, or, as a last resort, by Congres­
sional action. The crucial test will probably
come in 1975-76when the player association
and the team owners negotiate a new agree­
ment. One way out might be to combine a
more equal distribution of revenues for the
weaker teams with an option clause or long­
term contract for the players.

restriction on competition, but the bill died
in committee. The proposed bill to set condi­
tions under which an antitrust exemption
would be granted for the proposed basket­
ball merger also hints at the possibility of
government action. In any case, after the
player association, Congress may be the
most likely source of change in business
practices in the sports labor market.
A LOOK AT THE FUTURE

Economic analysis of the baseball labor
market sheds some light on the effects of the
present system and possible ways of modify­
ing it. Economic theory does not support the
claim that the player reservation system re­
duces the disparity between the strong and
the weak teams. Playing talent is probably
distributed much the same with or without a
reserve clause. Team owners benefit from
the restrictive labor practices because in­
come which would otherwise be paid to the
players is kept by the owners. Financially
weaker teams also benefit from the player




26

THE FED IN PRINT




a quarterly feature in this section is on vaca­
tion. The cumulative index of Fed monthly
reviews, compiled by Doris Zimmermann,
Philadelphia Fed Librarian, returns in the
September issue.

i

...

..

F D R LR S R EB N
E E A
E E V
A K

FEDERAL RESERVE BANK of PHILADELPHIA
PHILADELPHIA, JP E > > S Y IA A INIA 19105

business review
FEDERAL RESERVE BANK
OF PHILADELPHIA
PHILADELPHIA, PA. 19105





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102