By Pradeep Muthukrishnan
More than 50 years ago, Milton Friedman published his seminal essay “The Social Responsibility of Business Is to Increase Its Profits.” At the core of this manifesto, Friedman asserts that as long as a firm operates within the existing legal boundaries, any secondary activity, including the welfare of its workforce and its commitment to the environment, imposes a cost on the firm’s profits and steers it away from the above-mentioned goal. With this broad moral license, firms over the past half-century have increasingly adapted all internal functions to align with this primary responsibility of profit maximization. Such internal functions include labor policies, which have recently become a subject of debate in the wake of the Federal Trade Commission’s April 2024 ban on noncompete clauses in employee contracts. A federal judge in Texas subsequently blocked the ban in August.
An estimated 30 million American workers — one in every five — are subject to noncompete agreements. What might explain their widespread use? For a profit-maximizing firm, retaining its value under an increasingly competitive business environment requires either technological innovation that drives up its efficiency (and, by implication, its profit margins) or finding a way to effectively reduce competition while staying within the bounds set by antitrust regulations. The former requires massive effort and capital outlay by firms. The latter is among the cornerstones of American competitiveness, and the 135-year-old Sherman Antitrust Act provides extensive legal safeguards to ensure that the markets for both products and inputs (including labor) remain competitive. This means that outright agreements by firms to reduce competition by staying away from each other’s employees or products constitute illegal activities and are subject to punitive actions. Noncompete agreements are a workaround to the dual challenge. They allow firms to reduce labor competition without violating the Sherman Act.
From the firm’s perspective, reducing labor competition has a number of benefits. It allows for a degree of stability, in turn helping the firm undertake capital investments. It also minimizes the costs that firms face in hiring, training and transitioning their workers, aligning with the profit maximization objective. On the flip side, however, research also shows that reducing labor competition prevents new knowledge from entering firms and adding to their existing knowledge base, hindering their innovation capabilities. Firms that enforce noncompete agreements may thus end up, paradoxically, forgoing some of the value that they’re seeking to retain through those very agreements. Regardless, it goes without saying that noncompetes harm employees’ career trajectories. With reduced options to pursue new career opportunities, employees bound by noncompetes lose out on wage increases amounting to as much as $300 billion annually.
In a recent working paper, my co-authors and I studied the economic implications of reduced employee mobility on firms. Specifically, we asked if such restrictions improve firms’ innovative capabilities and financial performance or harm them. For the study, we investigated a closely related but considerably more binding form of employee restriction called an anti-poaching agreement. This term refers to a set of bilateral and multilateral agreements between firms in which they agree not to solicit or hire each other’s employees. Such agreements have been found to be in violation of antitrust regulations, since cross-hiring is essential for a free labor market. While we focused on Silicon Valley firms, various industries in the U.S. have used such agreements to reduce employee mobility.
Pradeep Muthukrishnan
Our study’s findings, I believe, are readily translatable to the ban on noncompetes proposed by the FTC. Employee stability — whether the result of noncompetes or anti-poaching agreements — leads to increased innovative capabilities and improved financial performance, and those positive outcomes significantly outweigh any potential improvements in innovation that may come through knowledge transfer. With the reasonable assurance that their key workers will remain in their employment, firms undertake substantially higher capital investments in their R&D activities and produce higher-quality patents. In turn, these firms perform better financially, increasing their stock prices and market capitalization. Following the legal crackdown on anti-poaching practices, complicit firms not only lose their advantage but actually perform worse than they would have had they never resorted to such practices. It’s also worth noting that a large portion of monetary benefits gained over this period through anti-poaching agreements was not transferred to shareholders (as profits) but instead paid out to senior executives. Firms, therefore, cannot claim to meet their moral obligation of increasing shareholders’ wealth.
The FTC’s attempt to ban noncompete agreements is a significant step that lowers friction to employee mobility. This policy would undoubtedly improve the career trajectories and boost the wages of millions of Americans. At the same time, however, it is also vital for policymakers to consider the country’s innovation output in the current global landscape. A District Court found that the ban is beyond the powers vested in the FTC, and it is likely that the ban’s fate will end up in Congress if the U.S. Court of Appeals rules similarly. Either way, any revised ban on noncompetes would benefit from a well-rounded framework to jointly address the needs of workers, firms and investors. A prudent policy ought to consider all-around interests and, at a minimum, prescribe strategies for firms to increase employee stability and transfer profits to the shareholder without unduly penalizing employees.
