Banning Noncompetes Is Good for Innovation

The FTC’s announcement that it plans to adopt a rule banning noncompetes nation-wide should be understood as more than simply a move to protect workers, although it is that. It’s also a big step forward for competition and innovation, and it will make businesses stronger in the long run.

Noncompetes have a harmful effect on talent mobility, entrepreneurship, and equality. They restrict employees from switching employers or starting their own competing business. Those restrictions depress wages, reduce entrepreneurship, and impede efforts to correct inequities.

In the past decade, a wealth of research — empirical, experimentaland theoretical studies — offers compelling evidence about the key role that human capital policy, including noncompete contracts, plays in industries and regions. These studies overwhelmingly show that the harms of noncompetes extend not only to employees but to also companies and regional innovation. Noncompetes reduce market dynamism and interfere with a free market for labor. They make it harder to start new companies and cause industries to become more monopolized by incumbent firms. And they reduce employee motivation and knowledge sharing, the fundamental building blocks of innovation.

Locking employees up with noncompetes not only dims their external prospects but also decreases their ownership of their own human capital and work, reducing their incentives to perform and develop their skills in the first place. When talent is locked up, the job market becomes “a market for lemons” — that is, a market where it is difficult to ascertain the quality, skill and past experience of candidates. In such a market, businesses end up with employees who are trapped in a job they aren’t passionate about. When companies don’t let employees leave for greener pastures, the result is “quiet quitting.” That means unhappy employees and unsatisfied employers.

A natural experiment on noncompetes

California and Massachusetts present a paradigmatic natural experiment on the effects of noncompetes. Massachusetts has long enforced noncompetes — and only recently in 2018 passed a law limiting their use, based on the mounting economic research about their harms. California has always deemed noncompetes void.

Both states were well positioned in the early 1970s to become the global high tech hub that Silicon Valley is today. Yet Massachusetts high tech companies’ use of noncompetes made it harder for talented employees to start their own ventures. By contrast, the computer industry accelerated in California, and inventor networks in the Bay Area became denser, even as it stagnated in Massachusetts around an older generation of companies.

What’s more, California as a whole benefited from its comparative policy advantage. It experienced brain gainas the best talent worldwide was attracted to the freedom California offered.Existing companies benefited too, because a free labor market meant that companies who were doing well could hire new employees. And the state benefited from the tax base that a robust market economy could bring.

An example like this isn’t perfect — lots of factors contributed to the rise of Silicon Valley — but combined with the depth of research already discussed it reinforces the fact that noncompetes stifle innovation. Moreover, impressive innovation in California in the absence of noncompetes holds true not only for the tech industry in Silicon Valley, but also with regard to other industries such as the biotech and pharma industries and the entertainment and content industry in Southern California.

Intellectual property is about balance

A healthy innovation policy requires balance. For example, intellectual property (IP) law balances the desire to give innovators some insulation from competition against the risk that locking up too much IP will stifle the very creativity the law is supposed to protect. Noncompetes have no similar balance. They are a blunt tool that wholesale prevents a person from taking a job in their chosen profession, sometimes for years.

There are better tools for achieving a balance between workers’ ability to switch jobs and start companies and employers desire not to see their R&D walk out the door. In California, where noncompetes have always been unenforceable, business have at their disposable other means to protect their inventive activity in fine-tuned ways. Most relevant is the strong protections afforded to trade secrets. Every state protects trade secrets and in 2016, Congress passed the Defend Trade Secrets Act (DTSA) to further provide strong secrecy protections federally. Trade secrecy strikes the right balance by focusing on narrower limits on the use of specific information rather than blanket prohibitions on competition.

Noncompetes help no one except dying companies — those who can’t compete to hire the best talent and can’t survive in the innovation marketplace. Everyone else — growing companies, new companies, employees, and the economy — benefit from a free, dynamic labor market where employees can move freely and companies compete for their talent. Unfortunately, advocates for those dying companies are out in force attacking the FTC’s proposal, in the pages of the Wall Street Journal and elsewhere.  he FTC is right not to let the dinosaurs of the past hold our economy back.