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To Compete or Non-Compete
The Biden administration’s Federal Trade Commission (FTC) is proposing the ban of non-competes. How economists (somewhat) made this happen.
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Non-compete agreements have become very prominent in the US. Over 30mln workers are covered by such arrangements. Workers from a variety of sectors and incomes have such agreements, even including Amazon warehouse employees. What are non-competes, why are they popular, and what does research say about it?
What are non-competes
Non-competes are clauses in contracts that usually prevent employees, after resigning from a company, from either starting or joining a trade or profession that could directly compete with the employer. Non-competes can be present in any industry or job. However, the ability to enforce them can vary. If a non-compete is too onerous on the employee, it can be voided in a court of law. For example, if a non-compete prohibits an employee from working for a very long period of time or bars employees from working for very many companies, courts and country laws might nullify them. Interestingly, certain states in the US, such as California and North Dakota, have laws making non-competes completely unenforceable, but firms still issue them.
Why do we have non-competes
Non-competes are a tool designed to address a market failure. A ‘market failure’ occurs when there is an allocation of goods or services that will leave everyone better off (this is referred to as Pareto improving allocation). There are many market failures that non-competes attempt to address. The two major ones are:
Company Trade Secret and Intellectual Property – a firm might be worried that if an employee leaves they will be able to utilize company proprietary knowledge and undermine the company. Thus, the company may decide to keep some of this information away from the employee. This hurts the firm and employee, as neither can be as productive as they could be.
Training – a company invests in training to improve their employees productivity. However, since the employee could leave to a competitor after the training, the company would have provided costly training with no benefit to them. This results in the company under providing training, resulting in both the employer and the employee being worse off. More generally, this is known as the “hold-up” problem, where two parties would benefit from cooperating, but cannot due to concern that one side will profit at the expense of the other.
Non-competes are meant to deal with those issues. If that’s all they did, they would be a great tool in dealing with the above mentioned market failures. However, there are two issues with non-competes. First, as we’ll soon see, non-competes do not address the above issues well. Secondly, there are other costs associated with non-competes that result in them being non-Pareto-improving tools (i.e. at least one party ends up worse off than in a world with no non-competes).
Evidence on Non-Competes
Workers, Wages and Training
The first component of non-competes that needs to be evaluated is do they actually increase productivities of the employee and the firms. Starr (2019) estimated that moving from a state that has no non-compete enforcement, to a state that has an average level of non-compete enforcement, increases firm provided training by approximately 14%. Although this potentially shows that productivity is increased, Starr (2019) also found that wages for employees with non-competes actually fall by 4% when non-competes are enforced.
The cause for the wage fall could be driven by several factors. One, less obvious factor, is that employees undertake less self-sponsored training when they have a non-compete compared to employees that don’t have non-competes, offsetting any gains from the additional firm-sponsored training. That is precisely the argument made by Garmaise (2011), who showed that CEOs and managers with non-competes undertake much less self-sponsored training than managers without non-competes. Moreover, the managers reduce self-sponsored training by more than the firm increases firm-sponsored training, which resulted in them having lower compensation than managers without non-competes, since they have less training overall. It is worth pointing out that Starr (2019) did not find any reduction in self-sponsored training in response to non-competes. In part, this difference in results could be driven by the fact that each of the two studies looked at different populations – Garmaise (2011) focused on employees that were managers or above, while Starr (2019) had a broader set of employees. However, both studies showed that wages do fall with non-competes.
Starr (2019), on the other hand, argued that the fall in wages is driven by the fact that employees are restricted with their outside options, and therefore weakening the employees bargaining power in negotiations. In the appendix, I elaborate on how economists model this behavior. Regardless of the cause, however, wages do appear to fall, on average, for workers with non-competes relative to workers without such contracts. There is evidence that in certain professions, wages are higher for employees that have signed non-competes. Kurt, Simon and White (2020) found that primary care physicians that sign non-competes have higher wages at the beginning and throughout their career. This was caused by an increase in intra-firm referrals (getting patients via a recommendation from another individual within a company). Non-competes therefore do alleviate some of the ‘hold-up’ problem (in this case, the referring of patients to the physician), as firms do not have to worry about referring patients to a physician that might leave (and take the patient with them to a competitor). Starr (2019) found that how early one is notified about the non-compete matters as well. Early notification of non-competes (two weeks prior to commencing a job) results in higher wages for employees compared to a late-notification. Notification appears to influence the bargaining process, with early notification allowing employees to bargain for more wages.
Firm Value and the Economy
Non-competes may appear to benefit firms since they may reduce worker’s wages. But that does not include many other ways non-competes might actually impact firm performance. Garmaise (2011) looked at whether firms with non-competes perform better or worse. He found that non-competes appear to be irrelevant for firm value. Since Garmaise (2011) also found that non-compete employees may reduce some of their self-sponsored training, this would offset any benefits. Furthermore, since non-competes are more likely to impact the whole market (competitor firms will also have employees with non-competes), the free flow of manager and workers between firms may be curtailed. Firms lose out from potentially hiring employees from competitors, and, thus, there is less knowledge diffusion. Another possible explanation for why non-competes are not valuable to firms is provided by Krakel and Sliwka (2009), who argued that by preventing employees from getting outside job offers, non-competes block a potential signal of employee quality. Since it is generally difficult to assess whether a worker is productive, external job offers can serve as a quality signal.
Regarding the wider economy, non-competes have been unambiguously shown to reduce labor mobility. McAdams (2019) summarized the literature on labor mobility and found that monthly job transitions increase when non-competes are removed by 8% to 26% more monthly job-to-job transitions. Furthermore, there is evidence that non-competes reduce the entry of new firms and the creation of spin-outs. Starr, Balasubramanian and Sakakibara (2016) found that the probability of creating a spin-out reduces with non-compete enforceability. Samila and Sorenson (2011) found that when there is an increase in venture capital activity (implying that new industry is developing, similar to the current AI hype), states with higher enforceability of non-competes see fewer patents, fewer new firms, and lower employment. This suggests that non-competes do have strong market effects.
The above is occasionally used to explain why Silicon Valley developed so much better than a similar technology hub in the Boston Area by Route 128. Route 128 was used to be synonymous with technology development during the 60s and through the 80s. Today, that is no longer the case. One argument is that since California did not enforce non-competes, there was greater diffusion of knowledge, which resulted in much faster growth in the technology sector compared to Route 128.
Non-competes appear to be an ineffective tool. They reduce wages, labor mobility, knowledge diffusion and firm entry, which are all costly for the economy. Overall, non-competes seem to not even be beneficial to firms. Firms might not be aware of these costs since they are not very tangible – it is difficult to estimate the loss due to the fact that a firm receives less knowledge or that it is not able to effectively observe employee performance. Removing non-competes would most likely be a net positive for society.
Removing non-competes, however, does not allay the concerns of firms regarding the issue of providing training to their employees and sharing trade secrets with new hires. This hold-up problem can be resolved in other ways – Krakel and Sliwka (2009) propose other forms of contracts that could deal with the issue without the negative consequences. For example, the authors mention that contracts can include clauses that would terminate certain post-employment benefits (i.e. pension plans, profits interest) if a worker were to join a competitor. By putting a monetary value on joining a competitor, incentives for employees and firms are aligned, since as an employee you will know exactly how much you will lose if you join a competitor, but you can still be rewarded for performing well. Non-compete clauses are, therefore, a bad tool that have serious economic costs, while the issues non-compete clauses attempt to alleviate, can be fixed with other contract features.
Economists typically view a firm and a worker as a match. When a firm and worker meet, they would only enter into an agreement if by working together they generate economic surplus (i.e. they are better off together than separate). Surplus is generated when the firm and worker match produce more than what they would do separately (referred to as outside option). A firm is usually assumed to not have any outside option – if it doesn’t hire a worker, it doesn’t produce anything, so it would always prefer to have a worker. A worker on the other hand has many outside options – they can choose to be unemployed (receive unemployment insurance), they can stay at home and work in the home (conduct valuable household activities such as raising children) or they can wait to match with a better firm (waiting for a different company to post a job). The worker’s outside option clearly has significant value. The worker would never work for less than their outside option. Thus, when the firm and worker meet, the output they produce must be more valuable than the worker’s outside option. Everything above the worker’s outside option is called economic surplus. To illustrate, if a worker’s outside option is valued at $30,000, the firm and worker pair must produce more than $30,000.
If there is economic surplus, the last issue is how this economic surplus is divided between the firm and the worker. Using the above example, suppose the output the firm and worker produce is valued at $50,000. The worker needs to be at least paid $30,000 (so that they choose to work). This leaves $20,000. This remainder needs to be split between the firm and the worker. Typically, economists model it as bargaining, and whoever has a stronger bargaining position gets more of this $20,000. If an employee is irreplaceable (literally), the employee could get the entire surplus of $20,000. Thus, their salary would be $50,000. However, typically employees are replaceable, which strengthens the bargaining position of firms. If we assume equal bargaining strength, the worker would be $40,000 (since they get the outside option of $30,000 plus half of the surplus, $10,000), while the firm has a profit of $10,000.
Non-competes impact the wage of the worker by weakening the worker’s outside option. Using our above example, suppose the firm all of a sudden forces the worker to sign a non-compete. Since a non-compete prevents the worker from getting a better job, their outside option now must be lower than the previous $30,000. Suppose it drops to $20,000. Using the same assumptions, the worker’s pay would now be $35,000, and firm profits would be $15,000.
Let’s add one more element – training. Training makes a worker more productive. This both helps the current firm and all other potential firms. Thus, the output of the firm and worker match is higher, but also the worker’s outside option is higher since the worker is more qualified. In a world without non-competes, training a worker might not be beneficial. Suppose a firm with a trained worker makes output valued at $55,000, as opposed to the original output at $50,000. The training cost is $2,000. Thus, training increases the output value by $5,000 at a cost of $2,000, meaning it is a worthwhile investment. However, given this worker is trained, the outside option of the worker goes up, as other firms will value this trained worker more. Suppose it goes up to $32,000. The economic surplus is now $55,000 – $32,000 = $23,000. Dividing this equally, the wage the firms will have to offer to the worker is $33,000 + $11,500 = $44,500. The firm receives $11,500. But since it had to pay the $2,000, it will have only $9,500 in the first year, which is worse than if it did not offer training (when the firm made a profit of $10,000).
By adding a non-compete, the worker’s outside option would not respond to the training, since they cannot work for other companies that would benefit from this training. Using the non-compete example, where the worker’s outside option was $20,000, by training the worker, the total output will again be $55,000. Since the outside option does not change due to training, the economic surplus will be $55,000 - $20,000 = $35,000. The worker’s wage would then be $20,000 + $17,500 = $37,500, while the firm gets $17,500 - $2,000 = $15,500. The firm would invest in the training.
In this simplified model, the non-compete appears to be valuable for the firm and results in the provision of the training. However, this model does not include all the other elements that are discussed and play a significant role: workers can choose to train less and firms might be less productive if they do not meet different workers.
Cover photo by RODNAE Productions
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