Michael Hicks: The end of noncompete clauses

The Federal Trade Commission last month ruled against noncompete clauses on employees, a decision that affects all for-profit firms and all employees except for a few senior executives.

Noncompete clauses are contracts between businesses and their employees that prevent an employee from taking a job with a competing business. These are always justified on “trade secrets.” They’ve been common for senior executives for many decades, but they have spread to cover almost a third of workers. The most ridiculous example is among fast food workers.

Almost the entirety of noncompete clauses are made to prevent wage competition among workers.

There are two legitimate criticisms of the FTC’s ruling. The first is simply that the ruling is too broad for a regulatory agency, and the ban on noncompete clauses should’ve been the work of Congress. I’m deeply sympathetic to the argument that Congress has ceded too much rulemaking to regulatory bodies. However, the FTC was created specifically to engage with monopoly behavior that evolves quickly.

The second criticism is that the FTC ruling doesn’t affect nonprofit firms. Nonprofits are among the largest abusers of this tool of monopolies.

For example, hospitals in Indiana are mostly nonprofit (despite being among the most profitable industries in the state). They are exempt from this ruling, so we have only two choices: wait for state or federal laws to end the practice or for the Department of Justice to sue.

There are three big benefits to ending most noncompete clauses.

The first, obvious benefit is that it makes it simpler for workers to change jobs and pursue better wages or working conditions. The FTC’s ruling benefits all workers, as well as businesses that offer competitive wages, benefits, working conditions and opportunities.

The second benefit is that the end of noncompete clauses will boost business dynamism.

Many affected businesses complain that increased competition for workers will hurt them and the economy. That claim is only half-true. Businesses that have shielded themselves from competition through noncompete clauses will need to do better. This might make them less profitable and force some to go out of business. That might be bad for the business owner, but it is not bad for the economy.

A dynamic, growing economy depends not only on business growth and expansion, but also business failure. Noncompete clauses inhibit business dynamism by trapping workers in less productive companies. By removing restrictions on workers seeking better employers, we allow the free movement of labor to its more productive use, where workers are also better compensated.

Noncompete clauses act as a profit subsidy to businesses that cannot compete for workers in local labor markets. The FTC’s actions force them to become more productive to compete on wages and working conditions. Firms that fail to do so will shrink or close. That not only moves workers, but also releases their buildings and capital to more productive firms.

The final and biggest benefit of the FTC ruling is that it weakens monopolies. Noncompete clauses keep wages low by preventing workers from seeking jobs with competitors. But noncompete clauses also squeeze out other forms of competition.

Professional services firms, such as law, accounting or engineering firms, employ people with very specific skills and a great deal of on-the-job training. These workers also develop local clients. If an employee becomes dissatisfied and wishes to open their own business, a noncompete clause would prevent them from doing so locally. In this case, a noncompete clause slows the formation of new, competing businesses.

Noncompete clauses also are part of what is known as “vertical foreclosure.” That is when a business buys or controls its suppliers to a region, preventing other businesses from entering the market. It can happen in many economic sectors, but it is most common in health care.

Healthcare systems can vertically foreclose the hospital market by purchasing medical practices. These physicians or groups of physicians refer patients to hospitals. An independent physician may refer patients to different hospitals based upon the price of the service or the perceived quality. However, once a practice is bought by the larger healthcare system, they will only refer patients to the hospital.

In many places, including the healthcare market where I live and work, IU Health has spent the last decade and a half gobbling up local medical practices. The local hospital is extraordinarily profitable, so it is an attractive place to locate a new clinic. However, there are too few untethered physicians to accept patients at a new clinic.

The noncompete clause reinforces the strength of hospital monopolies by preventing physicians from opening a competing practice locally and referring patients to other (less expensive) hospitals. Sadly, the FTC ruling won’t make medical care less expensive in my region because this highly profitable local hospital is, well, a not-for-profit. I’ll have to wait on legislation.

The FTC’s ruling isn’t an immediate panacea, but it comes at a time when the economy is strong and employers and workers have good information about labor market options. It should hasten better wages for many workers, boost the prospects of good companies, and direct human capital and physical capital to more productive businesses. That is all good news.

Michael J. Hicks is the director of the Center for Business and Economic Research and the George and Frances Ball Distinguished Professor of Economics in the Miller College of Business at Ball State University. Send comments to [email protected].