The Economics of Noncompete Contracts

In a "noncompete contract," an employee signs a contract with an employer not to work for a competing firm for some period of time. The usual justification for such agreements is that it would be unfair an employee who has detailed knowledge of trade secrets or customer contracts to take that information to a competitor.

But about 18% of all US workers are covered by noncompete contracts, and it seems unlikely that they are all in possession of sensitive corporate data. As a Forbes magazine article reported in 2014, the Jimmy John's sandwich chain was requiring sandwich makers and drivers to sign a noncompete contract in which they agreed that when they stopped working for Jimmy John's they would not work for “any business which derives more than 10% of its revenue from selling submarine, hero-type, deli-style, pita and/or wrapped or rolled sandwiches,” if that new employer was located within three
miles of any of the 2,000 Jimmy John's restaurants anywhere in the country.

The Office of Economic Policy at the U.S. Department of the Treasury has published a useful overview of these issues in its March 2016 report: "Non-compete Contracts: Economic Effects and Policy Implications."

Non-compete agreements are contracts between workers and firms that delay employees’ ability to work for competing firms. Employers use these agreements for a variety of reasons: they can protect trade secrets, reduce labor turnover, impose costs on competing firms, and improve employer leverage in future negotiations with workers. However, many of these benefits come at the expense of workers and the broader economy. Recent research suggests that a considerable number of American workers (18 percent of all workers, or nearly 30 million people) are covered by non-compete agreements. The prevalence of such agreements raises important questions about how they affect worker welfare, job mobility, business dynamics, and economic growth more generally. This report presents insights from economic theory and evidence on the economic effects of non-compete agreements. It goes on to discuss policy implications, starting a discussion about how such agreements could be used in a way that balances the interests of firms with those of workers and society as a whole.

It's obvious why employers like noncompetes. What's less clear is whether noncompete contracts serve a broader social interest. As the US Treasury report explains, the standard argument for noncompetes sounds like this:

fThe conventional picture of a workplace characterized by non-compete agreements is one that features trade secrets, including sophisticated technical information and business practices that firms have a strong interest in protecting. By preventing a worker from taking such secrets to a firm’s competitors, the non-compete essentially solves a “hold-up” problem: ex ante, both worker and firm have an interest in sharing vital information, as this raises the worker’s productivity. But ex post, the worker has an incentive to threaten the firm with divulgence of the information, raising his or her compensation by some amount equal to or less than the firm’s valuation of the information. Predicting this state of affairs, the firm is unwilling to share the information in the first place unless it has some legal recourse like a non-compete contract.

Moreover, a noncompete can be a way for firms to seek out employees who intend to remain with the firm for a time. When the firm that knows its workers will not be decamping for the competitor down the street, it finds it easier to share trade secrets and company methods across all workers in the firm, and to provide training in these methods as needed.

Of course, it's hard to see how these justifications apply to those working as drivers for Jimmy John's. Indeed, the report offers an array of suggestive evidence that noncompete agreements often don't have a lot to do with trade secrets and training. The study cites a variety of evidence along these lines.  For example:

• Non-competes are common among workers who report lower rates of trade secret possession: 15 percent of workers without a four-year college degree are subject to non-competes, and 14 percent of workers earning less than $40,000 have non-competes. This is true even though workers without four-year degrees are half as likely to possess trade secrets as those with four-year degrees, and workers earning less than $40,000 possess trade secrets at less than half the rate of their higher-earning counterparts.
• Available evidence suggests that workers with a low initial desire to switch jobs are not more likely to match with employers who require non-competes.
• In some cases, non-competes prevent workers from finding new employment even after being fired without cause; in such cases, it is difficult to believe that non-competes yield social benefits.

Noncompete contracts often include provisions that are not enforceable under state law: for example, state law in California makes noncompete contracts (with a few limited exceptions) essentially unenforceable, but 19% of California workers sign such agreements. Noncompete contracts are often presented to workers as part of the paperwork that they need to sign when showing up for their first day on the job, which doesn't suggest that they are part of a negotiation between employer and prospective employee about access to trade secrets and future training. There's even some evidence (which at this stage I would characterize as "real, but weak") that signing a noncompete causes less future job mobility and even lower future wages on average.

There's also an interesting big-picture story looming here. Histories of the development of Silicon Valley in its early years have often talked about the extremely fluid employment culture. The legends say that an engineer could have a tiff with the boss one morning, walk out the front door of the company and across the street to a competing firm, be hired, and be working for the other firm that same day after lunch. The point is that while California companies might have preferred to have noncompete contracts, these were not enforceable in California. As a result, engineers to come work in California, and the flow of workers between companies encouraged the flow of ideas and innovation, while also encouraging companies to offer high compensation and an attractive work environment.

However, the US Treasury report is quite mild-mannered in drawing policy conclusions, my own reading of the evidence is that noncompete contracts are often overused. The law of labor contracts is largely determined at a state level (whether by legislation or by case law), so if I was in state government, I would be thinking seriously about writing laws that place limits on noncompete contracts.  Some states, following the example of California, might prefer the clean sweep approach and come close to outlawing contracts with only a few exceptions. (Of course, rules about stealing trade secrets would still apply.) Other states might prefer more incremental reforms.

For example, the report notes that some states require that workers receive a "consideration"--that is, something of value in addition to their regular job pay--in exchange for signing the noncompete. Certain kinds of training that involves trade secrets might be one kind of answer. Another would be to require that severance pay be linked to the noncompete. As the report notes:

Some firms already provide severance payments to workers with non-competes. For instance, a worker who quits may receive 50 percent of her previous salary in exchange for abiding by the terms of the non-compete. This limits the harm to workers while ensuring that firms retain the ability to protect their interests with non-competes. Importantly, by requiring that firms incur a cost when requesting a non-compete, this policy preserves the most socially valuable non-compete agreements and discourages the least valuable, for which firms would not be willing to pay.

As another example, states could require that noncompete contracts cannot delay someone taking a job with a competitor for more than a certain period: for example, Oregon recently passed a law limiting noncompetes to 18 months. Or states could pass laws that noncompete contracts won't apply to anyone in a job paying less than $15-$20 per hour, or that they won't apply to workers in certain industries. Or states could pass a law that firms can only put language in a contract which is enforceable under the law of the state, to avoid the California-style scenario where 19% of workers are signing contracts that they often do not know are unenforceable.

The presumption in a market-oriented economy should be that workers are free to switch between jobs when they wish to do so. Employers who want to keep employees have many tools to do so, including paying bonuses related to length of time on the job. Noncompete contracts may occasionally make sense, but they should be a great deal more rare than they currently are.

Hat tips: For some other commentary on the US Treasury noncompete report, see the post by Nick Bunker at the Washington Center for Equitable Growth website, and the article by Justin Fox at the Bloomberg View website.