Protect or Prevent? Non-Compete Agreements and Innovation

A large proportion of the US workforce is covered by non-compete agreements (NCAs), but recently their use has become one of intense policy debate, with the FTC recently proposing to ban them. In this paper, we examine what effect such a policy change might be expected to have on innovation, and what the optimal policy would be. We consider four main channels that make the impact of NCAs on innovation ex-ante theoretically ambiguous: incumbent innovation incentives, entry, external spillovers, and internal spillovers. Our work suggests that at their current levels, NCAs have a significant negative impact on innovation, in contrast to what is often assumed in policy discussions. The impact is not only strongly statistically significant but also economically significant – for the mean observed change in state-level enforcement in our sample, patenting would be expected to move in the opposite direction by 11.8%. Moreover, this effect does not appear to simply be a story of NCAs restricting entry, with the fall in innovation almost exclusively being driven by incumbents. This suggests a potentially central role for labour markets and employee networks as a source of innovation spillovers. Therefore, we develop a GE model with endogenous innovation, search and matching frictions, and heterogeneous firms, allowing us to study optimal policy