One of the most exciting, powerful, and famous uses of arbitrage is in professional baseball. Here's the puzzle in a nutshell, "How the heck do you compete with the Yankees?" Because they have the largest market, they have the greatest ability to pay players without losing money. This ability to pay the most should assure them of the best players, which explains their dominance. That's the end of the story, right? Wrong. If that's the whole story, then how did the Oakland A's, with the second smallest payroll in Major League Baseball, generate so many wins in 2000, enough to make the playoffs? And how did they do it again in 2001, 2002, and 2003? There's something missing in the above story.
What's missing is arbitrage. A few years ago, the Oakland A's general manager Billy Beane--what a wonderful name for someone in baseball--did some great thinking that led to some great decisions. He noticed that baseball scouts had a huge effect on who was hired and that they were using what seemed like pretty subjective criteria for their recommendations. "Does so and so look like a baseball player?", for example. They also recommended many high school players, about whom little could be known because of the paucity of data on high school players relative to the abundance of data on college players. But what data would you want to look at? Surely runs batted in and batting average, right?
Well, not quite. A baseball analyst named Bill James had found, based on reams of data, that the scarce resource in offense was avoiding outs. So someone who gets on base, whether through a hit or a walk, is doing a huge service to his team. Beane and his assistant, Harvard economics graduate Paul DePodesta, were familiar with James's work. By measuring on-base performance, they found a lot of diamonds in the rough, so to speak, that is, players who were being ignored by the other teams and whom, therefore, they could hire at pay that was well below the value he estimated for their performance. Then Beane would lock them into contracts and get a lot of wins. This is arbitrage: finding resources that the market is valuing too low, hiring them at this low value, and then using them in high-value uses.
What Billy Beane was doing was in the same spirit as what 17-year-old Pat Parker did with his lead keels. In Parker's case, all he needed to realize was that the keels were worth more as scrap lead than as keels. In Billy Beane's case, it was a little more complicated. He realized that baseball had not yet adjusted to the fact that high-risk prospects were getting paid millions where their counterparts 25 years earlier, before salaries had soared, were getting on average less than $100,000. So the economic return from investing in information had soared. But virtually the whole of Major League Baseball was stuck in the old ways of judging players. The information technology revolution dramatically lowered the cost of getting information and processing it. With a lower cost of getting information and a higher benefit of getting it, Beane did the rational thing: he got more information. Beane then used the information to find those undervalued resources and then to arbitrage them by keeping enough good ones for his own team to win and selling off enough good ones to keep the Oakland A's financially viable.
The above is an abbreviated version of one of the most outstanding economics books published in the last 10 years. It's not billed as an economics book: it's a baseball book. And even someone with zero background in economics can understand it totally. The book is Moneyball by Michael Lewis. Not coincidentally, Lewis has previously written about successful businesses. It took someone with his sophisticated eye to see what now appears to almost all of us as an obviously good strategy. And it took someone with Lewis's writing ability to write about the economics of baseball in such a seamless way that you think you're reading a mystery novel rather than an economics book. Interestingly, though, many baseball owners still don't get it. According to Michael Lewis, other baseball owners are picking up on Billy Beane's method, the Boston Red Sox and the Toronto Blue Jays, to name two. But as long as enough other owners don't get it, Billy Beane and like-minded general managers will keep picking $100 bills off the street.