Massey and Thaler use football (the NFL) to demonstrate that markets may not be "rational."
From their abstract:
"Using archival data on draft-day trades, player performance and compensation, we compare the market value of draft picks with the historical value of drafted players. We find that top draft picks are overvalued in a manner that is inconsistent with rational expectations and efficient markets and consistent with psychological research. "The short version of their paper is that they examine the relative worth of various draft postions and then compare what they teams pay for the pick with what they get from the pick in on field performance. To get at this, the authors must first construct a price for draft position schedule based off of trades:
"For example, a team might give up the 4th pick and get the 10th pick and the 21st pick in return. In aggregate, such trades reveal the market value of draft picks. We can compare these market values to the surplus value (to the team) of the players chosen with the draft picks. We define surplus value as the player's performance value--estimated from the labor market for NFL veterans-- less his compensation. In the example just mentioned, if the market for draft picks is rational then the surplus value of the player taken with the 4th pick should equal (onaverage) the combined surplus value of the players taken with picks 10 and 21."The high price for higher picks (the article goes into detail of the Giants' acquisitionion of Eli Manning from the Chargers) suggests that there must be a large drop-off in quality since the price of signing the players also drops with position. Again in the authors' words: "both in terms
of pick value and monetary cost, the market prices imply that performance must be highly predictable."
Overall, the authors find that teams tend to overpay for the top picks. This of course this is similar to the Barber and O'Dean Glitter paper and Bernstein's Inept model in which exciting or glamorous assets tend to be overpriced.
Massey and Thaler:
"Our findings suggest the biases we had anticipated are actually even stronger than we had guessed. We expected to find that early picks were overpriced, and that the surplus values of picks would decline less steeply than the market values. Instead we have found that the surplus value of the picks during the first round actually increases throughout the round: the players selected with the final pick in the first round on average produces more surplus to his team than than the first pick, and costs one quarter the price!"While I loved the paper, I do have a few reservations. The author attempt to address the first one but with only partial success. They investigate the "Michael Vick factor". That is the idea that even though his on field performance may not be great, he brings people into the stands. They investigate this by looking subsequentent contracts and find that it is only on field performance that matters.
However, it is possible that in trading up, the teams are willing to overpay because of the added excitement (and coverage) that the higher picks generate. Thus, in the early years the team sells more tickets. (This becomes particularly important for a GM that has a short contract).
My second thought on this is that higher picks presumably have a wider variance of performance. If you take the view that team is buying a real option, the wider the variance on performance, the more valuable the pick.
Interestingly, both of these factors could explain why Quaterbacks seem to be be picked higher in first round than performance might warrant.
But no matter how you look at it, the paper is very interesting and does draw into question whether the market for draft picks is rational. And I will definitely use it in class!
Cade Massey and Richard Thaler. The Loser's Curse:
Overconfidence vs. Market Efficiency in the National Football League Draft, Working paper. Downloaded 7/27/05.
Want another football paper? Try this one on using Football to teach finance.