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More On Noncompete Clauses

Here’s a letter to a regular correspondent:

Mr. W__:

Thanks e-mailing in response to my defense of noncompete clauses. You raise a relevant point, which (as I understand it) is this: Because of transaction costs, it’s impossible for individual employees to negotiate personalized contractual terms; therefore, large corporations offer workers take-it-or-leave-it terms. Many workers will thus find themselves working under employment contracts that aren’t ideal.

I’ve two thoughts for now.

First, costs of transacting are as real and relevant as are costs of fuel, office space, and other inputs used to operate a business. And just as the cost of, say, fuel causes businesses to economize on fuel, so too do the costs of transacting cause businesses to economize on transacting. Thus, economizing on transacting does indeed limit the degree to which employment contracts are customized to each worker’s personal preferences. The optimal degree of employment-contract customization falls short of complete flexibility and individualization. Given the costs of transacting, this outcome is genuinely desirable, not lamentable.

If a particular firm gets it wrong by allowing too little contract customization, firms that supply greater customization will attract a disproportionately large number of high-quality workers. The result will be either that the mistaken firm comes to provide greater customization, or its market share shrinks until it goes bankrupt. In other words, failures by some employers to offer optimal employment-contract customization are profit opportunities for other employers. (Ditto, by the way, for a firm that offers too much contract customization.)

The upshot of this reality is that there should be a strong presumption that the prevailing degree of contract customization is optimal – meaning that if the degree of customization were greater, the costs to employers of providing this extra customization would be so high that some other terms of employment, such as wages, would be lower.

Second, the only condition under which the competition described above would generally fail to ensure optimal contract customization is if employers have both monopsony power in hiring labor and monopoly power in selling outputs. In reality, these conditions are highly unlikely. But even if we assume that these conditions prevail, the case for outlawing noncompete clauses remains weak. The reason is that outlawing noncompete clauses would do nothing to address the underlying problem of monopsony and monopoly. Outlawing noncompete clauses would simply cause employers to recapture for themselves the lost value of such clauses by lowering the value of workers’ wages, fringe benefits, or other terms of employment.

Your charge that “at some point very large corporations take on the character of a state, even if they are private entities,” is one with which I strongly disagree, but that’s a topic for a later reply.

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030

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