Here’s Peter Mannino’s Featured Comment on my recent post:
Isn’t the entire case against non-compete clauses exactly that they stifle dynamic efficiency? Imagine if the traitorous 8 couldn’t leave Shockley to found Fairchild semiconductors, or Noyce and Moore couldn’t leave Fairchild to found Intel. California’s hostility to non-compete’s is one reason why we have a tech sector… I guess the problem is that some business practices prevent the world from being a place where “entrepreneurs know they can profit as they please if they make their firm great.”
Plenty of people do indeed make this case against non-compete clauses. But their effect on innovation is far more complicated than it looks.
Suppose you have a great new idea. To implement your idea, you have to share it with eight crucial employees. But once you share it, any of these employees can take their knowledge and found a new firm to compete with you.
In this scenario, non-compete contracts are actually a great way to foster competition. How? By reassuring businesses that if they invest in new ideas, their employees can’t steal them at the first opportunity. What’s the point of creating or implementing new ideas if your hired helpers can readily betray you?
If this argument seems odd, notice that it’s structurally identical to a simpler argument. For example: Wouldn’t it be great for innovation if every firm had to make all their business secrets publicly available for free? On the surface, this makes perfect sense: Every aspiring innovator could quickly learn everything that every existing innovator already knows. Cornucopia! On reflection, though, this would be dynamically disastrous. What’s the point of coming up with new ideas in the first place if you have to give them all away gratis?
Question: If I’m right, how can California be so innovative? My best guess is that existing non-compete clauses are so weakly enforced that there’s little de facto difference between the law in California and the law in any other state. And in any case, the legality of non-compete clauses is only one of many ingredients of dynamic efficiency. So why care about this one? Because, per the Sorites’ Paradox, even minor ingredients add up. Wise policy-makers will focus on enhancing overall dynamic efficiency whether or not any specific policy seems especially crucial.
READER COMMENTS
Chris H
Jul 27 2018 at 1:04pm
Well slow your roll a bit on this dynamic case because it’s not nearly dynamic enough!
The implicit assumption here is that monetary motivation is the most important choke point on creating innovation, more important than sharing ideas more widely or being able to iterate on ideas without fear of lawsuits or simply being able to work outside the constraints of protecting the IP from being copied. Add these factors in and the result may be that the overall effect of weakening the monetary returns via fewer non-competes or less IP enforcement is more innovation. That’s an empirical not a theoretical question of course and I haven’t done the research to really see which effect predominates. However, the concentration of innovation in California despite numerous other disadvantages (high rents due to zoning laws, numerous regulations, bad tax policy, etc) is at least suggestive that in the current US overall policy environment, a bigger constraint on innovation is the sharing of and right to iterate freely on information than the monetary returns to innovation.
Peter Hurley
Jul 27 2018 at 1:20pm
This is a case for Non-disclosure agreements and/or patents, not noncompetes. An NDA is a contract prohibiting exfiltration of particular confidential business information, which is what you say needs protecting.
A patent would protect such information regardless of any contractual arrangement.
What is the case for noncompete agreements given that NDAs and patents exist?
Maximum Liberty
Jul 27 2018 at 6:26pm
1. It is easier to get evidence of violation of a non-competition agreement than of a non-disclosure (or more exactly, a non-use) agreement.
2. Patents require some level of novelty. Much of the software-side of technology is applying technology in fairly obvious ways. That can still be a trade secret. (E.g., “we know that these 13 approaches didn’t work, and the combination of all of these 32 of them did.”)
3. Proving a patent or trade secret violation can be as hard as proving a breach of an NDA, if the invention or trade secret is not exercised publicly.
Brian Beck
Jul 27 2018 at 2:56pm
I’ve litigated a lot of trade secret, patent, and non-compete cases, and this isn’t right.
“To implement your idea, you have to share it with eight crucial employees. But once you share it, any of these employees can take their knowledge and found a new firm to compete with you.”
No, they can’t–in this scenario, your idea is a trade secret, and regardless of whether there’s a non-compete agreement, the employee can’t take the trade secret and found a new firm. Even in California, that’s illegal (most recently, the entire Waymo v. Uber litigation was about this scenario).
A non-compete is broader, forbidding the employee from competing at all, even without using company information. Traditionally, they’re justified on one of two grounds:
The employee is in such a critical role that the employee knows essentially all the trade secrets the company has. So, if the employee leaves, the employee won’t be able to avoid even unintentionally exploiting the company’s confidential information and trade secrets. This is why non-competes are much more likely to be found valid where applied to executives and high-tech engineers.
The employee, as part of their work for the employer, developed strong customer relationships. As those customer relationships were developed on the employer’s dime, the employee shouldn’t be allowed to take those customers and form a new company.
The law in most states regulates non-competes along these lines, finding them only enforceable when limited in time, geography, and subject matter to achieve these objectives. That balance makes more sense than allowing unrestricted non-compete provisions that chain specialized workers to their job (if you specialize in a certain field but are restricted from working in that field, you can’t leave your job without switching industries and taking a significant pay cut).
That being said, I think you and Peter Mannino are both wrong about California; I don’t think their non-compete law had that significant an effect on innovation. I don’t know of any evidence that companies chose to locate in California or to stay in California because of its non-compete law. It would be interesting to go back and look at the legislative history to figure out why the California legislature passed its prohibition on non-competes in 1941; given the timing, I’d guess the film industry with its short-term projects and high employee turnover had a lot to do with it.
michael pettengill
Jul 27 2018 at 4:03pm
Any idea that when shared with 8 employees who can quit an found a competing company is a very small, pretty worthless idea.
Consider the idea of making rockets that takeoff, orbit, and then land back tail first. I saw that idea in the 50s-60s in sci-fi movies.
Elon Musk had an idea that required a rocket and traveled to Russia to try to buy one, with no luck. So, he decided to start a rocket company. He could not find any rocket engineer to work for him, so he invested his own $50 million and became his own rocket engineer. He ended up putting every penny he had into SpaceX and Tesla and had to borrow money to support his family, just to try to replicate what 15-20 government contractors had done, but at a lower cost. Only after he got his fourth rocket to work did his PayPal pals invest money so he could do more work to win business, and critically a NASA contract, to build the first few working revenue producing rockers.
It took several billions of dollars to land the first stage back tail down like in those old movies.
Ideas are pretty much worth the air required to say them. Big valuable ideas are valuable because billions in wages must be paid to turn them into something producing revenue. The free ideas cost thousands to hundreds of thousands. Ie, selling hot dogs costs a thousand for a food cart, but hot dogs and burgers will probably cost a hundred thousand.
California took over when it gave shares instead of pay to the early workers of startups to get them to work cheap, instead of simply paying good cash like on the east coast. In both places, capitalists provided cash to pay workers at startups, but in the 90s, lots more capitalist were created when workers of successful startups quit and sold their shares. Those with ideas could now pay workers to turn ideas into products, or provide cash to people with ideas to pay workers.
But, still, in California, most of the ideas turned into businesses in startups are really cheap ideas. Software apps. Toys like desktop 3d printers.
The big ideas require big capitalists able to put in fifty million to get to the point of hundreds of millions in cash investment, to get to selling out or IPO. Bezos committed to at least $5 billion 15-18 years ago to build rockets. Branson committed at least a hundred million in partnership with others. Several people left SpaceX to build smaller rockets like the first one Musk built requiring tens of millions. And quite a few have tried to start electric car companies and wasted millions by not having enough capital commitment.
Google today innovates the same way firms innovate on the east coast: it funds research projects and when ideas are interesting enough commitments of tens of millions are made, which become ongoing investments. Google maps, translate, are the product of probably a billion in investment over a decade to get to a viable product.
An interesting idea in silicon will require at least a billion dollars. 99.999% of the time you need to work for a company like Intel, etc.
Peter Mannino
Jul 28 2018 at 1:05pm
The other point against non-compete’s is that they make labor markets artificially thin. I didn’t include this in my last comment because I’m not sure if this is considered dynamic efficiency.
“Suppose you have a great new idea. To implement your idea, you have to share it with eight crucial employees”… but none of them are allowed to work for you.
Iskander
Aug 6 2018 at 8:52pm
On the whole I tend to dislike non-compete clauses. That said don’t they encourage firms to spend on human capital investments for their workers?
If the worker can leave, they won’t bother investing. There are other, less collusive, ways to get human capital investment however.
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