University of Virginia Legal Working Paper Series
University of Virginia John M. Olin Program in Law and Economics Working Paper Series
Investing in Human Capital: The Efficiency of Covenants Not to Compete
Abstract
Covenants not to compete (CNCs) are used in employment contracts to prevent employees from working for other employers. The legal enforcement of CNCs varies across jurisdictions in the U.S.: some states ban them (notably, California) while a majority of other states enforce CNCs when they reasonably protect a legitimate interest of the employer. The discrepancy in the legal policy regarding CNCs is reflected in an academic debate over the economic efficiency of these covenants. One side argues that CNCs are bad because they restrict labor mobility; the other side argues that the restriction on the movement of workers is good because it prevents workers from appropriating their employers’ human capital investments (and CNCs thereby encourage such investment). This paper addresses together the two objectives of ex post (labor mobility) and ex ante (human capital investment) efficiency. It compares CNCs with the alternative contract breach remedies of specific performance and liquidated damages. A given CNC may be analyzed as a hybrid that adopts specific performance with respect to attempted movements to employers within its scope and liquidated damages equal to zero with respect to movements outside its scope. Among the results of the paper is the finding that, where a CNC can be renegotiated, first-best performance and first-best investment can be induced. The appropriate choice of the CNC scope can balance perfectly the overinvestment tendency of specific performance against the underinvestment effect caused by zero liquidated damages. Contracting parties, however, have the incentive to agree to excessively broad CNCs that enable them to extract rents from prospective new employers within the CNC scope. The law should be wary of this incentive in policing CNCs.
Subject Area
Contracts, Employment Practice, Law and Economics
Recommended Citation
Eric A. Posner, Alexander Triantis, and George G. Triantis,
"Investing in Human Capital: The Efficiency of Covenants Not to Compete"
(October 2004).
University of Virginia Legal Working Paper Series.
University of Virginia John M. Olin Program in Law and Economics Working Paper Series.
Working Paper 11.
http://law.bepress.com/uvalwps/olin/art11
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