Competitive Edge: Why noncompete clauses in employment contracts are by and large harmful to U.S. workers and the U.S. economy

Antitrust and competition issues are receiving renewed interest, and for good reason. So far, the discussion has occurred at a high level of generality. To address important specific antitrust enforcement and competition issues, the Washington Center for Equitable Growth has launched this blog, which we call “Competitive Edge.” This series features leading experts in antitrust enforcement on a broad range of topics: potential areas for antitrust enforcement, concerns about existing doctrine, practical realities enforcers face, proposals for reform, and broader policies to promote competition. David J. Balan has authored this contribution.

The octopus image, above, updates an iconic editorial cartoon first published in 1904 in the magazine Puck to portray the Standard Oil monopoly. Please note the harpoon. Our goal for Competitive Edge is to promote the development of sharp and effective tools to increase competition in the United States economy.


David J. Balan

Researchers in recent years have compiled a substantial and impressive body of empirical evidence on the economic effects of noncompete clauses, which are often included in labor contracts between U.S. workers and firms. While somewhat mixed, this evidence mostly indicates that noncompetes are harmful to workers and to the U.S. economy overall.

This recent empirical evidence stands in tension with older theoretical arguments claiming that noncompetes are beneficial to both workers and firms. How that tension should be resolved depends on the strength of the arguments. If the arguments were extremely strong, then it might make sense to believe them, even in the face of substantial (but imperfect) empirical evidence to the contrary. But if the arguments in favor of noncompetes are weak, or if there are valid arguments against them, then the tension disappears and the natural conclusion is simply that noncompetes are harmful.

In this column, I argue for the latter position. Specifically, I describe and critique each of the three main theoretical arguments that are commonly made in favor of noncompetes, namely that:

  • The worker and the firm both voluntarily agree to the noncompete, which justifies a strong inference that it is mutually beneficial and economically efficient
  • Noncompetes facilitate efficient knowledge transfer from firms to workers
  • Noncompetes facilitate efficient firm-sponsored investment in worker training

Let us examine each of these arguments in turn.

Noncompetes only exist because they benefit both workers and firms

The first argument goes as follows. The fact that the noncompete was agreed to by both the worker and the firm strongly indicates that it is mutually beneficial. To be sure, all else being equal, the worker would prefer not to have a noncompete because it restricts their ability to leave the job or to use the threat of leaving to improve their bargaining position. But all else is not equal. A noncompete can only exist if the worker agrees to it, and the worker does not have to agree; they always have the option to refuse and take their next-best alternative option instead.

In other words, the firm cannot impose a noncompete on the worker. Therefore, the firm can only induce the worker to accept a noncompete by offering some other contract terms that are sufficiently attractive to cause the worker to agree. That is, a noncompete will only exist if the worker has been sufficiently compensated by the firm.

The next step in this argument is that the firm will only be willing to pay that compensation to the worker if it derives an efficiency benefit from the noncompete that is at least as large as the payment. So, if a noncompete exists, the compensation must have been big enough that the worker was willing to accept it and small enough that the firm was willing to pay it—thus, it must be mutually beneficial. And if the noncompete benefits both parties, then it must also be economically efficient in the sense of increasing total economic surplus (as long as it does not harm any third parties).

This argument depends crucially on the premise that imposing a noncompete on the worker without compensation is impossible. That is, the argument requires that the worker’s formal agreement to the noncompete provision can never be obtained unless the provision truly makes the worker better-off. This premise is rather obviously incorrect. There are, in fact, a number of ways that firms can impose noncompetes on workers without compensation. These include:

  • The firm can mislead the worker about the existence or the meaning of the noncompete.
  • The firm can wait until the worker starts the job before informing the worker of the existence of the noncompete, exploiting the worker’s reluctance to quit and restart the job search.
  • The firm can impose on the worker an interpretation of the noncompete that is more restrictive than what was originally agreed to by exploiting the power asymmetry between the worker and the firm in the ability to bear the costs of fighting in court.
  • The firm can simply refuse to deliver the promised compensation, knowing that the worker’s most powerful weapon to compel the firm to keep its promises—threatening to quit—is precisely what is deterred by the noncompete itself.

In response to the above points, it might be argued that even if it were possible for noncompetes to be imposed on workers without compensation, they would be dislodged by competition in the labor market because firms that do not require an (uncompensated) noncompete would attract workers away from ones that do. But this competitive pressure is likely to be weak, especially if noncompetes are already ubiquitous in an industry.

For a firm to succeed in attracting workers by not requiring a noncompete, it would likely have to make the absence of a noncompete a central element of its recruiting message to the exclusion of other, likely more effective messages. Moreover, if only one or a few firms did not require a noncompete, then they would tend to attract the workers who care the most about avoiding a noncompete. Those workers may be less desirable as they may be the workers most likely to quit. For these reasons, the ability of labor market competition to dislodge uncompensated noncompetes is likely to be limited.

For the above reasons, noncompetes likely can be imposed on workers without compensation. And if that is true, then the presumption that noncompetes must be mutually beneficial disappears—and with it the presumption that they are economically efficient. Rather, it becomes possible, even likely, that noncompetes are instead largely a means by which firms extract value from workers.

Commonly claimed positive effects of noncompetes

It is worth noting that the above argument does not depend on any specific claim regarding possible positive effects of noncompetes. Rather, according to that argument, the mere existence of a noncompete, and its voluntary nature, are taken to be sufficient to demonstrate that it must have large positive effects, otherwise the firm would not have been willing to pay the compensation necessary for the worker to agree to it. But, as discussed above, this argument is badly flawed, and noncompetes likely can, in fact, be imposed without compensation. This does not necessarily mean that noncompetes do not have positive effects (more on this below), but it does mean that those positive effects must be demonstrated and not merely inferred from the fact that the noncompete exists.

We now turn to the specific claims of positive effects that are commonly made in favor of noncompetes. There are two such claims. The first is that they facilitate efficient transfer of knowledge from firms to workers, and the second is that they facilitate efficient worker-funded employee training. We consider each claim in turn.

Noncompetes facilitate efficient knowledge transfer from firms to workers

The first claim is that noncompetes facilitate efficient information sharing, which, in turn, provides stronger incentives to produce valuable information. The claim is that a firm will have greater incentive to share knowledge with a worker, and even to generate new knowledge in the first place, if the knowledge is protected by a noncompete to prevent the worker from taking that information to a new firm. But there are a number of reasons to doubt this benefit is large, including:

  • Much information sharing will occur with or without a noncompete simply because it is impossible to operate the business any other way. The efficiency benefit is only the increment of information sharing that is induced by the noncompete (that would not have occurred otherwise), and that increment may not be large.
  • Noncompetes impede the efficient flow of information across firms. The experience of California, which does not enforce noncompetes but is a world-leading center of innovation, suggests that the benefits of this cross-fertilization of knowledge may be so large that impeding it with noncompetes is harmful to innovation, on balance. At a minimum, it strongly suggests that any innovation benefits from noncompetes are not very large.
  • By the same logic that the noncompete increases the firm’s incentive to generate new knowledge, it decreases the worker’s incentive to do so. The fact that a worker who creates new knowledge cannot use that knowledge to make themselves more attractive to outside employers reduces the incentive to create the knowledge in the first place.
  • Noncompetes also impede the efficient flow of people across firms. Some job matches are inefficient, and noncompetes impede them from being dissolved in favor of more efficient ones.
  • To the extent that noncompetes do facilitate efficient information sharing, those benefits can often be achieved through other, less restrictive means, including nondisclosure and nonsolicitation agreements.

Noncompetes encourage efficient firm-sponsored investment in worker training

The second claim of positive effects of noncompetes is that they facilitate efficient firm-funded worker training. The idea is that a firm will have a greater incentive to train the worker if a noncompete prevents the worker from taking that training to a new firm. But there are a number of reasons to doubt that this benefit is large, namely:

  • Some training will occur with or without the noncompete simply because it is impossible to operate the business any other way. Once again, it is only the increment of training that is induced by the noncompete that matters (that would not have occurred otherwise), and that increment may not be very large.
  • A noncompete does remove a barrier to firm-funded training because the firm no longer has to worry that the worker will use that training to get a better job offer. That is, with a noncompete, the firm can capture the benefit of the training and so is more willing to pay the cost of it. But standard economic theory indicates that, in a competitive labor market, training with benefits that exceed the costs will occur regardless. With a noncompete, the firm will pay the cost and receive the benefit, but without a noncompete, the worker will pay the cost (through formal schooling and/or lower wages early in a career) and receive the benefit. The training will occur regardless.

Appropriate policy response

If noncompetes are, in fact, largely a means for firms to extract value from workers, the question becomes what the appropriate policy response might be. In a companion article, I argue that noncompetes can reasonably be viewed as a problem appropriately dealt with in the context of the antitrust laws. In another article, FTC Commissioner Rohit Chopra and researcher Lina Khan argue that this problem can be addressed using the FTC’s rulemaking authority.

Conclusion

The empirical evidence, combined with the weakness of the arguments in favor of noncompete contracts and the existence of strong arguments against them, suggests that noncompetes are harmful, on balance. This harm may extend beyond the measures that economists normally consider, such as effects on job mobility, entrepreneurship, worker training, innovation, and wages. Rather, it is likely that noncompetes have other, even worse, effects. By making it more difficult to leave a job, noncompetes increase worker vulnerability to nonmonetary harms such as abuse and degradation. A predatory employer or manager who knows that the worker cannot leave will be more unrestrained in their predation.

Aside from all measurable harms, the ability of human beings to take their body and their labor where they choose is a fundamental human right. Perhaps some extremely strong economic efficiency benefits would be sufficient to outweigh this, but both the evidence and the theoretical arguments indicate that such benefits do not exist.

—David J. Balan is an employee of the Federal Trade Commission. The views expressed in this column are solely those of the author.

January 28, 2021

AUTHORS:

David Balan

Topics

Anticompetitive Conduct

Bargaining Power

Monopsony

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