Economic And Business Impacts Of FTC’s Noncompete Ban

The Federal Trade Commission has banned noncompete clauses in employment contracts. The rule—not a law—is being challenged in federal courts. The economic impacts will not be huge, but they will slow innovation in the economy as businesses seek alternative ways to protect their trade secrets.

Initial controversy surrounds wage rates. The FTC claims that noncompetes have suppressed wages, so the ban will boost wages. The contrary view has been expressed, including by Tyler Cowen. The simple idea is that employers and job applicants strike a bargain. If the employer wants a particular term that is not in the employee’s best interest, the employer will have to give up something else. If the employer demands a clause that hurts the job applicant, but does not provide higher wages or some other benefit, then that applicant will walk away and take a job elsewhere. Thus, people who agree to noncompetes probably receive a higher salary.

That model seems naïve to many people, who claim that employers have all of the bargaining power. Such an idea grew in the era from 1970 through 2010 when the labor force was growing substantially. The idea of a competitive market for labor sounds more reasonable today as many companies have struggled to hire and retain the workers they want. Along with Cowen, I expect wages to come down just a little in jobs that previously had been subject to noncompetes. People who shunned job opportunities because of noncompetes will now be willing to go to work at those companies. With more job applicants, wage offers will be less generous.

More interesting discussions concern innovation. The ban on noncompetes provides arguments in both directions, though I expect the net effect of the ban to be negative.

Consider a company that has spent some time and money to develop a valuable new idea which will not be patented. It could be a new ingredient in their secret sauce, or a way to find customers who will love their product, or a production technique that uses less energy, enabling both lower prices and high profit margins. Noncompete agreements allow the company to protect its intellectual property by ensuring that employees do not leave to work for a competitor, at least for a year or two.

Without noncompetes, the business will want to limit the number of employees who know the secret. Depending on the nature of the secret, it may slow down implementation of the secret or narrow the secret’s application. The company may decide that the secret should be limited to employees at the headquarters. Workers at local offices will not be told the secret, even though it would help them be more productive. Or the range of products using the secret will be limited to a few with centralized production, not including many with local production.

Stepping back in time, consider the initial decision to develop the secret. It may have required substantial investment of time and money. Without noncompetes, the secret is less valuable. Some research and development projects will not be undertaken if noncompetes are banned, slowing innovation across the economy.

On the contrary side, the economy benefits as innovation spreads throughout the country and the world. People who change jobs bring ideas with them, helping their new employers, which in turn helps the whole economy. (Alex Tabarrok has a good explanation.) This idea corresponds to patents and copyrights. A static view says we would be better today off if patents and copyrights were terminated right now. But we wouldn’t be better off in the future if innovation slowed down because ideas could easily be copied. Economic growth over the long haul will be better if innovators know they will capture much of the benefits of their work.

In light of the FTC decision, business leaders with significant intellectual property should re-think their operations with a focus on protecting their ideas. Limiting access to secrets would be one way. Compensation tied to remaining with the company would also help, as with stock options or bonuses that vest over time. Decisions about investing in the development of new ideas should be made with the understanding that a company’s secrets won’t stay secret for as long as they used to.

From a social benefit perspective, it’s worth recalling the conclusion of Nobel laureate William Nordhaus who studied innovation: “I estimate that innovators are able to capture about 2.2 percent of the total social surplus from innovation.”