I am a lifelong fan of the San Francisco Giants. I waited a long time before they finally won a World Series in 2010, and then again in 2012 and 2014. Of course, now that they have won it a few times, I want them to do it more often; and I pay close attention to the roster moves they make. Recently I have been lamenting the salaries they are paying to some players, wishing the players would simply be paid for performance. Then I realized – baseball is just a good example of customer willingness to pay and is not different from other markets. Determining customer value compared to their next best alternative and pricing accordingly is an important part of maximizing profitability.
There was a time when baseball players had to play for the team that drafted them or had traded for them. Once the players were drafted, there was only one possible buyer for their services. Likewise, the teams did not have multiple options for potential suppliers of services. They had to either draft or trade for the players they wanted. There was no competition for buyers or sellers, so prices in the market tended to be limited. Once players were granted free agency, they could sell their services to any team. Similarly, teams could go after any player who was selling his services on the open market. With those conditions, baseball started behaving like a real market and pricing changed.
After 2014, the Giants’ pitching deteriorated, so the team decided to buy pitching services from the free agent market. Prior to the 2016 season, Jeff Samardzija offered his pitching services to all the MLB teams. He found a buyer, the Giants, who were willing to pay him $90 million over five years, all of it guaranteed. Similarly, prior to the 2017 season, the Giants needed a new closer. Mark Melancon was a closing pitcher offering his services. The Giants agreed to pay him $62 million over four years, all of it guaranteed. As a fan, I thought Samardzija and Melancon had gouged the Giants; but clearly, they just found the amounts the buyer was willing to pay. The Giants could have bought the services of other pitchers, but they were willing to pay all that money to Samardzija and Melancon, and the pitchers would have been crazy not to charge that full amount.
The argument many baseball fans make against these large guaranteed contracts is the players may not deliver that much value. Based on their results so far, Melancon and Samardzija have both significantly underperformed. Melancon missed most of the 2017 season with an elbow injury, and he has only pitched 5 innings in 2018. Samardzija played most of 2016 and 2017, but won only 21 games. So, he earned $1.7 million per win. So, why did the Giants pay so much? They did because they determined the pitchers’ value was higher than the Giants’ next best alternatives.
It occurs to me that hedge fund investors are a bit like baseball free agents. The investors are looking for investments that will perform better than others. Hedge funds gained popularity in the 80s when a few of them significantly outperformed the stock market. The hedge fund managers charged Two and Twenty for their services (2% of assets managed plus 20% of the gains), which is significantly more than traditional money managers charged. Investors have been willing to pay the extra fees, and by 2016, it was estimated that $3.2 trillion was invested in hedge funds. Much like baseball players, many hedge funds do not perform as well as anticipated. While some investors are reducing their exposure to hedge funds, there are still plenty of investors willing to pay higher fees in anticipation of potential greater value.
Why am I writing about baseball players and hedge funds? Because they illustrate the point about customer value and willingness to pay. The value of your product or service to a customer is always an amount compared to their next best alternative. Customers may be able to get something cheaper, but if they are convinced your offer provides something the alternatives don’t, they will be willing to pay more. Figure out what your customers are willing to pay and set your prices accordingly, even if those prices are substantially higher than competitor offers.