In Defense of Non-Competes

Non-competes reduce a fundamental contracting problem

Who could possibly be against “Promoting Competition in the American Economy”? I’m not. I love competition. Yet, I’m not sure President Biden’s recent executive order by that title will actually accomplish much to promote competition.

Instead of talking about the entire hodgepodge that is the executive order, in this week’s Economic Forces, I want to think more about one “problem” the executive order is trying to address: non-compete clauses.

(For brief reactions to the executive order as a whole, I’d read Sam Bowman, Tyler Cowen, or Alden Abbott.)

When you get out of college and get your first job, you may have to sign a document saying you will not work for a competitor for 12 months. These agreements are known as "non-compete clauses" or simply "non-competes."

These aren't some fringe thing. As of 2016 around 18 percent of workers in the US are bound by some non-compete. Many people are worried about non-competes. The big bad company is screwing me, the poor worker over! As the New York Times put it "The spread of noncompete agreements is one of many ways in which the workplace has been rigged against workers."

The Biden executive order uses similar language: “Powerful companies require workers to sign non-compete agreements that restrict their ability to change jobs.” The corporations sit there in their corporation buildings, and they're all corporation-y.

But contrary to what the New York Times may say, once we look at the economics a bit more closely, the voluntary signing of a non-compete can actually help workers. The world is not a Marxian struggle between workers and businesses. Sometimes people make mutually beneficial exchanges.

A key feature of the modern workplace, especially in high-tech industries, is that each side needs to invest before the worker is contributing. Workers need to invest time and effort to learn the ins and outs of the company, everything from the software systems to the informal norms. Employers need to invest in training the worker. When students get out of college, they have few skills that immediately help a firm. They don't even know Excel!

However, unlike investing in a new computer or 3D printer, these investments only retain most of their value to the firm if the worker remains at the firm. If the employer provides some training, the worker can turn around and immediately leave. The underlying economic problem is that if the worker needs some training the worker can screw over the company, not the other way around.

This is known as the hold-up problem. Once the worker has the skills, they can hold up the employer for more money or simply leaving the company before the worker actually contributes.

But as Ben Klein, Robert Crawford, and Armen Alchian pointed out back in 1978, the hold-up isn't the end of the story. Anticipating the possibility of the worker holding up the employer, both sides have an incentive to develop contractual workarounds. Klein, Crawford, and Alchian's insight was that the more investments are specific to a particular trading partner, the more likely we will see contracts tying the two sides more tightly together.

When I signed my marriage contract, I tied my own hands; that’s a good thing for both my wife and me. By making it harder (although not impossible) to leave for a different company, the worker is able to tie her own hands in a way that incentivizes the company to invest more in training. It is an economic exchange: the worker gives commitment in exchange for training.

None of this is to suggest that the current regime of non-compete clauses is perfect. I can explain how patents encourage innovation without supporting our current system that encourages patent trolling. Before I invest in an innovation, I want assurance that the investment won’t be stolen. Before a firm invests in a worker, they want assurance that the investment won’t be stolen. There are important transaction costs that patents (a policy) and non-competes (a contract) evolved to reduce.

I’m merely making the case for non-compete clauses, so we know what problem they evolved to solve before we try to change them through policy. Overall, if I had to take a stance on the policy, I’d come down with Tyler Cowen:

Contra to the recommendation, we should not ban non-compete agreements outright.  Many non-compete agreements are perfectly normal institutions designed to protect corporate assets against IP theft, client lists for instance.  We should restrict non-compete agreements in some more sophisticated manner, still to be determined.

So while to the proverbial laymen, non-competes look like they have to hurt workers, the underlying economics tells a richer story that we can’t forget.