Tuesday, June 08, 2010

Oliver Perez and Sunk Cost, a Discussion

An Adam Rubin article the other day about Oliver Perez and the concept of sunk cost got me thinking. I believe that most people, although they properly define what a "sunk cost" is, actually have the issue completely backwards. As for the Rubin article, for starters, the most pertinent parts of it went like this:
ECON 101

What’s spent is spent.

Sounds simple enough, right? Yet Major League Baseball teams often stick with things that aren’t working simply because they’re already on the hook to pay for it.

* * *

The bottom line: Are Mets officials keeping the struggling Perez around because he is a valued member of the 25-man roster, whom they are confident will have a pitching renaissance? Or are they loathe to releasing Perez -- who has declined to go to the minor leagues -- because he’s in the second season of a three-year, $36 million deal?
I happen to love Adam Rubin and think he's one of the best beat writers around - but I think he's a little off the mark here. But he's not alone.

A search of "Oliver Perez" and "sunk cost" on Google turns up over 1,700 results. Here are some other examples from other respected sources:

The Mets don't want to let Perez go because he's still owed about $20m through the end of next season, but that money's already gone. It's a sunk cost. The only reason to hang on to Perez is if you think he could again become effective, and there's just no evidence that that's a real possibility. --SB Nation

Recognize a sunk cost.
In 2011, the Mets will pay Carlos Beltran $20 million, Oliver Perez $12 million, and Luis Castillo $6.25 million. These are atrocious rates for players who are past their prime, untalented, or both. The Mets keep waiting around for them to earn their money rather than accepting that they never will. If Perez were not making $12 million this season and next, there is no way he would be allowed near a major-league rotation. Because he is, though, the Mets are doubling their pain. --New York Magazine
Seemingly everyone is seeming to make the same mistake when it comes to framing the issue. Rubin, and SB Nation, and Will Leitch over at New York Magazine (formerly Deadspin) frame the issue as one of pride, or hubris, or failing to recognize failures. All of them, and most fans who mention the concept, seem to believe that "sunk cost" simply means paying money for something that currently sucks, when there is something out there which can do the job better but more cheaply (one example was bringing up Dillon Gee, who might be just as good and make the minimum).

This oversimplifies things. There is no reason why Perez needs to "have a pitching renaissance" in the words of Rubin or "earn his money" in the words if NY Mag. Here's a concise definition as per wikipedia:
In economics and business decision-making, sunk costs are retrospective (past) costs that have already been incurred and cannot be recovered. In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that an economic actor not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits.
We can all agree that the contract given to Oliver Perez is a "sunk cost" because it was spent and cannot be recovered. In that sense, the definition provided by Adam Rubin in his article is accurate. However, it seems clear to me that most people depart from rational theory-based economics and view the issue emotionally. The most important issue to consider is this: if none of these ballplayers were paid anything at all, would Oliver Perez (based on his track record and potential) deserve a roster spot or any more time to find himself?

We can all agree on a lot of things. For instance, we can also agree that Perez was overpaid even at the time the contract was signed. But he wasn't just given the money for no reason -- he was worthy of a sizeable investment because of what he has accomplished in the past and what he may still accomplish in the future. The Mets paid for his present, which was tolerable, and his future, which may well have been quite good.

Looking at Oliver Perez today, it is hard to imagine that he was once so successful. It was impossible to predict his knee injury and subsequent loss of velocity. The main problem is, in fact, the fact that nobody really knows who this guy is anymore, or what he is capable of, or whether he will ever round back into form. The bottom line, however, is this: Perez was once a good pitcher, is young, and has the talent to be a serviceable player again in the future.

Viewed from one perspective, it is understandable to see that wanting to hang on to Perez "just in case" he puts it together for another team as a "lack of understanding of sunk cost" or prideful or hubris. I think that is an overly simplistic view of the facts.

I do not believe that the Mets are not holding on to Oliver Perez because they do not want egg on their face. I do believe, and I truly hope, that the Mets are holding on to Perez because they correctly view his contract as a sunk cost and that it doesn't matter what he is earning -- all that matters that he has an ability to put it all together and throw a baseball better than all but a few dozen people on the planet.

I can be long-winded sometimes, so let me get to the point. To me it is all a matter of perspective. Viewed retroactively, Perez has an enormous albatross of a contract and has not pitched well. But viewed with an eye toward the future, we do not owe him a penny more than what his current contract entitles him to, yet he has the ability to be a valuable part of any team's 25-man roster when he's OK.

The final entry on the wikipedia page for "sunk cost" mentions something called theBygones Principle. The section isn't properly cited, but the concept is sound:
The bygones principle states that when making a decision, one should make a hard-headed calculation of the extra costs one will incur and weigh these against its extra advantages. It emphasises the importance of only taking into account the future costs and benefits when making decisions.
Instead of criticizing the Mets for not understanding "sunk cost" as a reason THAT THEY SHOULD cut Oliver Perez, I would posit that most fans have the issue backwards. Since the contract is properly conceptualized as a "sunk cost", it should be completely irrelevant to our decision-making. Perez should be viewed as he is - team property for two more seasons no matter what. And with a resume like he has, he's not the kind of guy you want to cut loose for free.

Instead of lobbying for Perez to be released because we are all angry at the waste of money, the Mets have done the right thing by holding on to him. The issue is currently moot because Perez is on the DL, but with the MLB investigating his MRI he may not be there for long. We will see what happens when he gets back, but I for one hope the Mets don't give in to the pressure and cut loose a potentially valuable asset simply because he's making a lot of money. We are on the hook for the money no matter what, so all Perez needs to do is prove that he'll be able to pitch better than Elmer Dessens, or Raul Valdez, or whoever the last man on the roster will be. If he will go to the minors and work out his issues, even better.

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The funniest part of the Bygones Entry on wikipedia is that they use the example of a nuclear power plant to demonstrate how people misconcieve the idea of "sunk cost." In this example, Oliver Perez would be the nuclear power plant. I find that absolutely hilarious:

An important example of this is related to nuclear power. In the late 1980s, about two dozen partially complete nuclear power plants dotted the USA's landscape. Some had already absorbed billions of dollars of investment but were not yet ready to operate.

One particularly difficult case was the Shoreham plant on Long Island Sound, New York. By 1987 the owner had spent $5.5 billion on bricks, mortar, fuel rods, and interest, but the operating license had not been granted. From an economic point of view, the $5.5 billion of past investments should not be weighed in decision making processes.

The bygones principle would state that the $5.5 billion of past cost is irrelevant. From an economic point of view, the only relevant issue concerns future costs and benefits. That is, the economic benefits of the electricity that Shoreham would produce.

The key to observe in making this calculation is that the sunk cost of $5.5 billion is irrelevant to future costs and benefits. Studies indicated that, if the $5.5 billion were ignored, the future costs of the nuclear power plant would be slightly less than the next-best alternative, even though the total cost was far higher than the alternative. A purely economic analysis would conclude that the most efficient outcome would be to finish the construction and open the Shoreham nuclear power plant. However, citing many reasons, including the sunk costs, the plant was closed by protests in 1989 without generating any commercial electrical power.

4 comments:

AlfonsoG said...

I agree with your general analysis, but not your conclusion. There's also an important factor here that you leave out.

Yes, the Mets should be looking at whether Oliver Perez is worth more than the last guy on the roster, not at the money spent. But I really don't see any evidence to suggest that Oliver Perez is better than any other 25th man, and indeed he hasn't been for over a year. Sure, you lose nothing with him on the DL, but once that time is up if he's looking like he's looked for the last year, he should go.

The other issue is that you are keeping a man on your roster who is simply refusing to do what's best for the team. He's putting his own desires ahead of what works for the New York Mets (having him work out his problems in the minors). Keeping him on the roster sends the clear message that talent, even if no longer there, is more important than production and teamwork.

Brian Mangan said...

Excellent points, Alfonso (also, great name, obviously).

I conceptualize it like this.

Let's say we signed Perez for 2 years, $1 dollar per year. He's got this track record of success. How long would you stick with him to see if he can figure it out? If you're only paying him a penny per game?

I believe that he will be at least as good as whoever the Mets 25th man is. And that he has potential for better. If you think he is worse, and will always be worse, then I can understand why you'd want him released. But that's really the only justification.

section518 said...

Great post. I admit to throwing "sunk cost" into more than one argument, but you've made me think twice.

That being said, not all of Ollie's contract is truly "sunk". If they release him and another team signs him to the league minimum, the Mets are only obligated to pay him the difference between his contract and the minimum. If they replaced him with a player making the minimum, it wouldn't increase the total amount of money owed.

Put into the terms of your argument, that would give the Mets the option to either a) pay Ollie $1 for 2 years, or b) pay a replacement player $1 for 2 years. Ollie may still have the potential to be a productive member of the roster, but if they determine that Dillon Gee, Bobby Parnell or someone else has more potential they shouldn't hesitate to cut Ollie.

That being said, they clearly have some reason for not releasing him. Hopefully, it's an honest assessment of his talent.

Curtis said...

I took microeconomics some thirty years ago, and both parts of the definition you used were part of the definition we used. I agree with AlfonzoG's evaluation that Perez by himself is not worth keeping on the team for free. (Ask yourself whether you'd accept Perez as a free throw-in in a trade. No way.) Add in that you have to give zero out a spot on the primary roster, and that 'free' Perez is costing you. You're now carrying only twenty four men and a rotting carcass, while most of the teams you're playing will have one more bench option, defensive specialist or OOGIE than you will. He's hurting you, 'free' or not.

The nuclear discussion interested me because it reminded me of a case study we used to debate the limits of sunk costing. In our case (which MAY also have been true at Shoreham) the issue was that a project was budgeted as moneymaking at a cost of $2.3 billion. After having spent that amount, the project was not completed, due to unforeseen delays and overruns, but it could be completed for an additional $1.2 billion. Using the principal of sunk costing, the extra money was authorized, since the project was still believed to be potentially profitable.

Fast forward a year; the additional funds have been spent and the project isn't much closer to completion than it was before. Another evaluation is performed, profits are still foreseen and another $1.4 billion are authorized. Another year, another evaluation, another $1.7 billion.

At this point we were asked as a class how long this should continue. According to the principle of sunk costs, this project could run over by decades, end up costing four or five times what was originally considered its break-even value, and still more money could be thrown at it ad infinitum. All that would be required would be for the project managers to keep coming up with projections that the end was in sight.

Our class concluded that at some point (and the third revision of the original estimate was as good a point as any), somebody had to speak up and say, "This is a mirage. The estimates/projections are faulty and cannot be trusted. Stop throwing good money after bad."

Your mileage may vary.