Characterizing NBA Free Agency Market from an Asymmetric Information Perspective: Minimum Level Exception for Undrafted Free Agents
While the principles of markets for lemons and asymmetric information may not be popularly associated with sports free agency markets, there does exist a state of interaction that can be applied to determining appropriate compensation and contractual values of NBA players. We can apply some basic assumptions of markets for lemons and asymmetric information to the NBA Free Agency Market and investigate expected payoffs and revenue for teams and players; specifically analyzing the nature of undrafted free agents.
In the article, the authors dive into how the market for lemons model can fit certain free agency negotiations and dictate contract agreements in Major League Baseball (MLB). They looked at how the value fluctuates for players coming off the disabled list, and how asymmetric information about their health can change markets in free agency. It is quite eye-opening to see how certain teams are reluctant, as buyers, because of the lack of information about potential players. That hesitance may cause teams to change values and offer sheets to account for that unknown. As it applies to the NBA, I thought it could be interesting to look at how the free agency market could model a market for lemons with undrafted free agents coming into the league. There is a lot of unknown about these players, on top of the league having existing minimum salary levels. The minimum salary level could be constructed (in a markets for lemons) based on expected team revenue of productive v.s. unproductive undrafted free agents, with accountability associated to team risk.
Before one can try to theoretically apply the principles of asymmetric information to the NBA market, you first need to have a solid understanding of how NBA Free Agency is conducted. During a period in the offseason, players with expired contracts or newly professionals can field offers from all 30 NBA teams. Not every team is going to be interested in every player, as some teams are looking for specific positions or to fill specific needs. If a player doesn’t receive/accept an offer, they have alternative options to play overseas etc. From the player perspective, a player can go to only one team, so they can entertain as many offers as they like but they will have to end up choosing one team to sign a contract with. Additionally, a key component is that players naturally will have different levels of talent and skills. The market for better players is going to be in a higher pay bracket than it will be for “worse” players. While it may be hard to specifically classify the discrepancy between good and less good players, we have to acknowledge that it does exist. In the purposes of this investigation, we will only look at the market very generally, and only focus on undrafted free agents.
In the markets for lemons (used-car) examples, you have sellers selling their car and buyers looking to buy used cars. As it pertains to asymmetric information, the buyers can’t tell whether the quality of the car is good or bad. Their only instinct is their evaluation of the mixture of good and bad cars on the market. Depending on the circumstances, there can exist an equilibrium where used-car buyers expect a mixture of car qualities but we often see that issues arise because only the seller knows the true value of the car. Sellers can provide signals and information to convince buyers that the car is what they demonstrate it to be but the best market outcome usually requires full transparency.
In this scenario, we are going to classify the players as the sellers and the teams as the buyers. Specifically, we are going to focus on the market for undrafted free agents (classified as newly professionals). Teams can scout players by watching their college/overseas film or conducting informal workouts, but generally, only the players know how productive they can be for a team. The asymmetric information standpoint of this exists with that same notion. In the example of an undrafted free agent, if a player wasn’t selected in the draft, then it is a fair assumption that teams are intrigued but don’t know if they can accurately forecast their abilities and production. There have been countless occasions where a “better” player performed poorly and a “worse” player exceeded expectations in similar scenarios, therefore it is in the best interest of the team to take such risks.
Another key aspect in this is understanding minimum level contracts. These minimum salary exceptions are usually shorter deals where teams can sign players (usually veterans) to their roster for the minimum salary per the player’s years of experience/service time. This sometimes serves as a benchmark expected contract offer for teams unable to forecast a player’s value and unwilling to take a risk and pay them generously.
So here is what I devised as the Basic Assumption of Markets for Lemons — in the context of the NBA FA Market
- (i) There are different qualities of players — some are very productive for their NBA team while others may be less productive. This can affect the value that they will produce for their franchise.
- (ii) There exists consideration for an environment where different prior accolades demand larger salaries and stronger contract incentives. A team would be willing to sign a player if they could receive full transparency in their expected production, stats and system fit.
- (iii) Players (sellers) have a better sense of how productive they are gonna be for a given team (buyer). Asymmetric information does in fact exist in this market
- (iv) If teams can’t reliably determine the production levels of their free agency signings, then they won’t be able to sign only strong fits, and productive players. A rather standard minimum level contract can be in place to quart players who believe the contract is representative of their abilities.
This can be highlighted in the minimum level exception for NBA teams. Teams can offer players a minimum level exception when they can’t reliably determine the production levels of their potential free agency signings. Instead of taking a financial risk as the buyer, they can pay this “uniform” contract value and it’ll only be signed by players who think it fairly represents their skills. That expected value is similar to the uniform price expected outcome in the standard market for lemons, where buyers can’t determine the quality of the car.
As an example, for a currently undrafted free agent in the NBA free agency market in 2020, the minimum salary level is $898,310. We want to see if we can come up with a similar uniform minimum salary level for NBA Free Agency, given the market for lemon assumption and the existence of asymmetric information. There is no clear set percentage makeup to accredit players to a team revenue because team revenues are composed of many different factors of varying relative importance. Thus we can do a general estimation of that information…
| PRODUCTIVE NBA PLAYER |
UNPRODUCTIVE NBA PLAYER |
|
|
Team Expected Revenue |
$1,500,000 | $750,000 |
| Player Expected Salary | $1,000,000 |
$600,000 |
However, NBA teams can’t accurately forecast whether an undrafted free agent is going to be a productive NBA player so that raises the same question that the market for lemons warrants.
Hypothetically speaking, let’s say that based on historical data, half of the undrafted free agents in the top NBA FA market pool turn out to be productive. The expected team revenue would be ($1,500,000 + $750,000) / 2 = $1,125,000 and teams can offer that as the minimum level salary for 0 years of experience. It is a fair assumption that all undrafted free agents would hope for a shot to play in the NBA, there does not exist an expectation that only unproductive players are in the market.
The NBA is different from many other sports leagues and it is hard to determine the true percentage of productive undrafted NBA players (on a basis of quantifying production and quantifying what constitutes a productive tenure). The NFL has a “productive undrafted FA” percentage of about 30%. Despite the large number of differences between leagues, personnel and draft style, 30% can be a good starting benchmark for an estimation. Given the fact that NBA teams have smaller rosters, and the draft is only two rounds, a percentage of about 15% seems relatively reasonable.
If an NBA team expected all undrafted free agents to be on the market, and 15% of the free agents are productive NBA players, then the expected revenue would be (.15)($1,500,000)+(.85)($750,000) =$862,500 and teams can offer that minimum level salary for 0 years of experience.
Despite estimation of factors and large room for error discrepancy, the minimum level salary in 2020 is only about $30,000 off from what our general asymmetric information-market for lemon model accounted for.
Obviously this model doesn’t work perfectly because the NBA FA market is constantly fluctuating with the salary cap, NBA licensing deals and team cap space. Additionally, the NBA has much more intricate ways of determining the minimum salary levels based on other confounding variables that may deviate from a market for lemons type model.
In acknowledgement of all prior information, the model may not be most accurate representation of the market, but it is still interesting to view it from an asymmetric information perspective since it does partially exist within Free Agency team-player negotiations and the collective bargaining agreement.
Sources:
http://asbbs.org/files/ASBBS2012V1/PDF/E/EnzM.pdf
https://www.hoopsrumors.com/2020/11/nba-minimum-salaries-for-202021.html