Wednesday, 20 April 2016

Noncompete contracts

At the Conversable Economist blog Timothy Taylor discusses noncompete contracts. A noncompete contract is one in which one term in the employment contract states that the employee will not work for a competing firm for some period of time after leaving their current employer. What is the use of such contracts?

Taylor refers to a March 2016 report from The Office of Economic Policy at the U.S. Department of the Treasury: "Non-compete Contracts: Economic Effects and Policy Implications" (pdf). The report states,
The 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.
Also as Taylor explains,
[...] 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.
So in areas where hold-up problems could occur noncompete contracts can make sense. But as Taylor notes these contracts are used in situations where trade secrets, technical information and particular business practises are not a issue. For example,
[...] 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.
Its not clear what role noncompete contracts play here. After all if you want to know what is in a Jimmy John's sandwich you don't have to get one of their employees to work for you and tell you, you just have to buy a sandwich and take a look.

There is also the issues of whether such contracts are enforceable. As Taylor notes,
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.
I don't know about the situation in New Zealand.

Also firms have other measures they can take to protect information and keep employees. To protect information and relationships with clients law firms use an "up or out" procedure. After a time with the law firm you are either promoted to partner or fired. The timing of this decision is such that the lawyer in question  has had enough time to prove their worth to the firm but not enough to have gained enough information about the firm's clients and built a good enough relationship to get clients to move with them if they are fired.

Also when it comes to keeping good employees firms have a number of alternatives to noncompete contracts. The "up" option in the lawyer example or options such as paying bonuses related to length of time on the job.

So the question is, Are noncompete contracts socially useful?


Jim Rose said...

Beat me to ride in a post on this. the literature does not ask the basic question which is to induce workers to sign them, they must pay more In wages

Paul Walker said...

Jim. There is an interesting comment in the Taylor post, "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."