Saturday, 23 March 2013

West Ham, the Olympic Stadium, and the puzzle of sunk costs

Yesterday West Ham United Football Club were essentially given the London 2012 Olympic Stadium for the bargain price of £15 million. True, they will not own the stadium, and will have to pay rent. But, this does nothing to alter the basic fact that West Ham has been handed a bargain.
   And its a bargain deal that has annoyed many. The Stadium cost around £500 million to build and converting it into a football stadium is going to cost at least another £100 million. Most of this funding has come from the taxpayer. So, on face value it looks like the UK taxpayer is giving a football club a very big gift - a £600 million stadium for £15 million. To make sense of this we need to think about sunk costs and bargaining. 
    Let's look at sunk costs first. The stadium was built for the London Olympics, and not the benefit of West Ham. Spending £500 million on the stadium was, therefore, arguably money well spent by the British taxpayer. But times move on: the London Olympics has long finished, the stadium still exists, and the question that matters now is what to do with the stadium. The money spent building the stadium is a sunk cost, it's gone, and should not be a factor in current decisions. So, London Mayor Boris Johnson was right to be relatively upbeat about the deal. The taxpayer is going to get a revenue from the stadium that is much better than could have been hoped for without West Ham. 
    West Ham, though, are getting a fantastic deal. They are getting a fantastic, iconic stadium that they could not possibly have afforded themselves. And this will dramatically increase the value of West Ham. Indeed, we already have the example of Manchester City to illustrate how a 'stadium for free' can transform a club - they got the stadium built for the Commonwealth Games and have not looked back. The owners of West Ham have got a very good deal. The supporters will also soon get over the nostalgia for their current ground.
    The deal struck is thus one that benefits the taxpayer a little and benefits West Ham a lot. Why did we end up with such a one-sided deal? Bargaining theory can help explain. The first thing to keep in mind is that while the stadium cost £500 million it is not worth £500 million anymore. Its a liability for the tax payer and worth, say, £200 million for West Ham. So, the parties are bargaining over £200 million. Note that a second potential user of the stadium might have changed this equation but that did not materialize. The taxpayer is in a relatively poor bargaining position because it wants to off-load the stadium and declare the Olympics a success. West Ham is in a much more strong bargaining position because it can carry on using its current ground and does not have cash lying around to pay for the stadium. Its no surprise, therefore, that West Ham gets the better deal.
     This situation can be viewed in terms of the ultimatum game. West Ham offered to give the taxpayer £15 million of the £200 million the stadium is worth to them. The taxpayer can either accept or reject the offer. It makes sense to accept, because £15 million is better than nothing. But, it's annoying to accept because West Ham do very, very well from the deal. So, it's a matter of interpretation whether you think the taxpayer got a good or bad deal.


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