Academic journal article Economic Inquiry

Optimal Enforcement of Noncompete Covenants

Academic journal article Economic Inquiry

Optimal Enforcement of Noncompete Covenants

Article excerpt

I. INTRODUCTION

As knowledge-intensive industries have grown in importance in the last few decades, several recent studies have focused on the role of worker mobility as an important conduit through which knowledge is transferred across firms (Franco and Filson 2006; Franco and Mitchell 2008; Moen 2005). In a recent paper, Tambe and Hitt (2014) show that over the last two decades, productivity spillovers through worker mobility across IT firms have contributed 20%-30% as much to productivity growth as the firms' own IT investments. Shankar and Ghosh (2013) explain how worker turnover plays a unique role in optimally allocating worker knowledge in high-technology industries where firm-specific technological shocks create a continuous cross-section of expanding and contracting firms.

Given the apparent benefits of worker turnover among knowledge-intensive firms, many researchers have argued in favor of the free flow of ideas facilitated through employee mobility in these industries (Gilson 1999; Hyde 2003; Saxenian 1994). Employers, on the other hand, have generally attempted to restrict such transfer of knowledge via exiting workers. One such contractual restriction that firms and workers often enter into is a noncompete agreement, or covenant not to compete (CNC) clause. These agreements prevent employees from accepting employment in a competing firm for a specified period of time after they leave the current employer. Hence, by restricting worker mobility, they limit the flow of knowledge to competitors.

There are widespread differences from state to state within the United States in the extent to which CNCs can be legally enforced. Some states such as California have made such contracts completely unenforceable. At the other extreme, Texas and Massachusetts are known for being very permissive in their enforcement of such contractual employment restrictions. State-wise variation in the enforcement of CNCs has provided fertile ground for researchers to analyze the effects of labor mobility restrictions. Not surprisingly, several papers, such as Fallick, Fleischman, and Rebitzer (2006) and Marx, Strumsky, and Fleming (2009), show that more permissive legal enforcement of CNCs reduces worker mobility among firms. To the extent that labor turnover plays a positive role in the efficient allocation of worker knowledge and ideas across firms, these studies would suggest that CNCs have a negative effect on growth and productivity. Gilson (1999) and Hyde (2003), for example, attribute the success of Silicon Valley firms in California and correspondingly the failure of technology firms in the Route 128 cluster of Massachusetts to differences in CNC enforcement across the two states. Samila and Sorenson (2011) find that permissive enforcement of CNCs has an adverse effect on innovation. The research we have described thus far highlights the negative effect of CNCs on the incentive for workers to invest in developing new ideas and on the optimal transfer of such ideas through worker mobility.

On the other hand, it is arguable that CNCs can also have positive output effects by limiting turnover and allowing firms to protect their human capital investments and intellectual property, thereby enhancing such investments by firms. Kim and Marschke (2005) show that turnover of scientists reduces research and development expenditures by the firm. Starr (2015) shows that noncompete enforcement improves firm-sponsored training in certain occupations. Lavetti, Simon, and White (2015) find that noncompetes have a positive effect on wage and revenue generated by physicians. The hold-up of firms' investments in training and general human capital accumulation caused by labor market competition has been studied extensively in the literature. (1) However, the role of CNCs in mitigating this investment hold-up has received very little attention. Thus, our first objective in this article is to provide an integrated theoretical framework to explore all efficiency aspects of CNCs, namely, the efficient transfer of knowledge through worker mobility and optimal investment decisions by firms as well as workers. …

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