By Kenneth Glenn Dau-Schmidt (Indiana University) & Phillip J. Jones (Ogletree Deakins)
Agreements not to compete are generally an anathema to free market advocates. Independent profit maximization is one of the fundamental assumptions of the neoclassical economic model and necessary to its conclusion that markets yield results that are Paraeto efficient. Consistent with this theory, and practical experience, agreements among competitors, or potential competitors, to divide a market, or fix price or quantity are per se violations under our antitrust laws.
Despite this fact, even some ardent free market advocates have argued on behalf of the enforcement of covenants not to compete in the employment relationship. The traditional economic argument in favor of enforcing non-competes assumes that labor markets are competitive and workers freely enter into such agreements in return for higher wages associated with work in research on behalf of the employer and/or access to employer developed trade secrets and customer contacts. This arrangement is desirable to the employer because it helps protect his or her investment in research, trade secrets, and customer contacts, against appropriation if the employee were to leave to work for a competitor. It is argued that society also benefits from such arrangements because the increase to production from the employer’s investment in research and customer contacts would more than make up for societal losses due to the constraints on the employee’s labor mobility.
However, economic theory also embraces a more sinister view of such agreements. Given their constraints on labor mobility, there is a natural concern that employers might use non-competes to limit labor market competition and perhaps product market competition. Recent discussions of labor market monopsony power have cited the potential role of non-competes in extending employer power by creating “market friction” that prevents employees from selling their labor to the highest valued use. Under this view, the covenant not only allows the employer to pay the employee less than a competitive wage, but also raises the recruiting costs of the employer’s competitors, allowing the employer to charge higher prices. Concern about covenants not to compete is particularly acute when they are imposed on employees after acceptance of an offer of employment, clearly challenging the assumption that they are freely accepted in return for higher wages. In such cases a covenant not to compete can serve as an intertemporal conduit of monopsony power, translating the employee’s short-term disadvantage in the lack of an alternative offer into long-term employer monopsony power. Viewed in this light, a covenant not to compete is a socially costly restraint on the employee’s freedom to apply his or her labor to the highest valued use and receive a competitive wage.
Which of these two economic views of employee covenants not to compete is true, and under what circumstances, is an empirical question. The answer to this question can be very useful in helping us determine whether such agreements should be enforceable, and, if so, under what circumstances. This is a question of growing importance as the use of covenants not to compete has grown in our economy. Once largely confined to the instances incident to the sale of a business or involving highly compensated managers, professionals or research staff, the use of covenants not to compete has spread across the American economy until by the most recent count they cover 20% of American employees including many low-skill positions without access to sensitive information such as a hair stylist, yoga instructor, lawn sprayer, temporary warehouseman, sandwich-maker, dog-walker and even volunteer camp counselor and unpaid intern. Moreover, it seems that few of these covenants not to compete are the result of bargained for exchange and many are imposed by the employer after the job has been accepted and without additional compensation. The sheer number of these agreements and the potentially deleterious impact they might have on peoples’ careers, our labor market and our economy have brought this question to a head and provided impetus for possible remedial legislation at both the state and federal levels. Fortunately, there are a number of very good empirical studies that examine the number and circumstance of such agreements and the impact of these agreements on the workers, firms and our economy.
In this article, we examine the American experience with employee covenants not to compete. We discuss first their treatment under the common law and statutes codifying the common law. Next, we review the recent empirical literature and discuss its findings with respect to the current state of the phenomenon of covenants not to compete in the American workforce and their impact on the affected workers, firms and the economy as a whole. Based on this empirical work we conclude that covenants not to compete are over-used in the American economy having a deleterious effect on employee wages and mobility and the vibrancy of our economy, with no comparable increase in employer investment in research or training. Thus, we find that, for the vast majority of employees, the negative economic view of covenants not to compete is more accurate and such agreements are used to extend employer control over the employees and in some cases extend employer monopsony power. Employers also lose out due to covenants not to compete because they have become an obstacle to hiring qualified staff. Finally, we discuss efforts at the state and federal level to regulate the use of non-competes to ameliorate the abuse and problems of these restrictions. We examine these legislative efforts and evaluate them in light of the recent empirical work on the problems caused by non-competes.
