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Investing in Human Capital: The Efficiency of Covenants Not to Compete

35 Pages Posted: 3 Oct 2001  

Eric A. Posner

University of Chicago - Law School

George G. Triantis

Stanford Law School

Alexander J. Triantis

University of Maryland - Robert H. Smith School of Business

Date Written: January 2004

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 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). The paper addresses together the two objectives of ex post (labor mobility) and ex ante (human capital investment) efficiency. It compares CNCs with the 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.

Keywords: Covenant not to compete, employment, exclusive contracts

JEL Classification: K12, L14

Suggested Citation

Posner, Eric A. and Triantis, George G. and Triantis, Alexander J., Investing in Human Capital: The Efficiency of Covenants Not to Compete (January 2004). U Chicago Law & Economics, Olin Working Paper No. 137; Univ. of Virginia Law & Econ Research Paper No. 01-08. Available at SSRN: https://ssrn.com/abstract=285805 or http://dx.doi.org/10.2139/ssrn.285805

Eric A. Posner (Contact Author)

University of Chicago - Law School ( email )

1111 E. 60th St.
Chicago, IL 60637
United States
773-702-0425 (Phone)
773-702-0730 (Fax)

HOME PAGE: http://www.law.uchicago.edu/faculty/posner-e/

George G. Triantis

Stanford Law School ( email )

559 Nathan Abbott Way
Stanford, CA 94305-8610
United States

Alexander J. Triantis

University of Maryland - Robert H. Smith School of Business ( email )

Department of Finance
College Park, MD 20742-1815
United States
301-405-2246 (Phone)
301-314-9157 (Fax)

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