As currently formulated, antitrust’s rule of reason approach is not the best tool to deal with vertical noncompete agreements that limit worker mobility and result in suppressed wages or hamper workers’ opportunities for advancement. The focus should be on reasonableness rather than market power.

Does antitrust have a labor market problem? The last few years have seen growing interest among academic scholars in the causes and effects of concentration in US labor markets. Concurrently (and not unrelated), there has been an explosion of interest among policymakers and the general public in the impact that firms with market power may have on wages and working conditions. What do the data say regarding employer concentration and its effect on workers? Is antitrust in its current form equipped to address issues related to labor market power? In an attempt to answer these questions and more, we have decided to launch a series of articles on antitrust and the labor market.

US workers take home a smaller share of business profits than at any time in recent history. The decline is well documented and has provoked calls for fixes such as stronger minimum wage laws and more protection for labor unions

One additional option is increased antitrust enforcement for the benefit of labor, an obvious antitrust target being “horizontal” agreements among competitors to restrain worker mobility or salaries. For example, an “anti-poaching” agreement is one between two or more competitors that they will not hire away one another’s employees. Another example is mergers that eliminate competition in markets for hiring employees. While antitrust law could be doing a better job here, the fact is that it already has well-developed tools to address these issues. Existing merger law applies to anticompetitive outcomes in employment markets. The antitrust law of price-fixing and market division already covers labor market agreements, and the Justice Department is even pursuing wage-fixing agreements as criminal offenses.

By contrast, vertical agreements between a single employer and its employees are more ambiguous and problematic. They have never been as well understood as horizontal agreements. The law has wavered from regarding them suspiciously to seeing them as entirely benign. Most antitrust decisions dismiss the challenges.  Historically, the origin of the tension lay between two powerful common law concepts: liberty of contract, which protected voluntary agreements, and the almost equally powerful idea of restraints on trade that limited competitive opportunities. Courts sometimes simply upheld any bargained-for agreement. Other courts employed a “rule of reason” that focused on the duration and geographic area covered by an agreement. Some American states continue to follow these formulations, but state law overall is a patchwork of different requirements.

One important concern is vertical noncompete agreements that limit worker mobility. The harms are suppressed wages or other benefits, including opportunities for advancement. An unrestrained worker can apply freely to go elsewhere for a better position; a worker covered by a noncompete agreement cannot.

Purely vertical employee noncompetes are not illegal, per se, nor should they be. They can prevent the economically harmful free-riding that occurs when one employer is able to steal a different employer’s investment. Sometimes, employers invest a great deal in training workers and need time to recoup that investment. Other workers hold trade secrets or other valuable intellectual property that rivals would love to steal. These cases are exceptions, however, and the concerns do not generally apply to unskilled and semi-skilled employees. The courts need to address them individually, require employers to prove the justifications they offer, and explore less restrictive alternatives.

As currently formulated, however, antitrust’s rule of reason is not the best tool for this task, mainly because of its market power requirement. The relevant power is in the employment market, and advancement is often path-dependent to a specific employer. As a result, even employers with small market shares can get away with oppressive limitations on employee mobility. The focus should be on reasonableness rather than market power.

“even employers with small market shares can get away with oppressive limitations on employee mobility. The focus should be on reasonableness rather than market power.”

The current rash of noncompete agreements involving low-salary employees in food franchises is particularly problematic. In a franchise system such as McDonald’s, the franchisor controls the system, but individual franchisees are separately owned and operated as small businesses. The overall product market is fairly competitive: even McDonald’s, the largest franchisor, has a little over 20 percent of the market. The franchisor contracts with each franchisee individually, but the franchisees ordinarily do not contract with each other. McDonald’s and other fast food franchises increasingly use noncompete agreements between the franchisor and each franchisee that prevent even low-level employees from moving from one franchise location to another. McDonald’s agreement provides that an individual “Franchisee shall not employ or seek to employ any person who is at the time employed by” a different McDonald’s franchisee.

The economic literature often treats franchises as alternatives to single multistore firms, and for good reasons. They are substitute mechanisms for organizing production in an entity with several locations or branches. Nevertheless, there can be important differences. A single employer who owns all of its branches or stores would not ordinarily prohibit employees from bidding for opportunities at a different location within the same firm. Employees’ ability to compete for advancement is good for both the employer and the employees. Indeed, intra-firm promotions requiring an employee to relocate are common.

So why do so many national franchises forbid employees at one location from moving to another location within the same franchise system? The most plausible answer is that these are disguised horizontal agreements among the individual franchisees. One important difference between franchises and unitary firms is that each franchisee is a distinct profit center. They have an incentive to collude that commonly-owned branches in a single firm do not have. In that case, these noncompetes operate more like horizontal no-poaching agreements than classical noncompetition covenants. 

Occasionally, a revealing fact comes out. For example, the Jimmy John’s franchise agreement makes any individual franchise a third-party beneficiary of a noncompete. This means that one franchise can sue a different franchise for an intra-franchise hire prohibited by the agreement. Further, most of the free-rider justifications for noncompetes do not apply among franchisees to a common franchisor. A particular Jimmy John’s location is unlikely to have trade secrets or unique training that it needs to protect from a different Jimmy John’s franchisee. If that is the case, then they should be treated as “naked” restraints, with no offsetting social benefit, and subject to harsh antitrust treatment.

Intra-franchise noncompetes are in fact “hub-and-spoke” conspiracies, which are agreements among a group of horizontal competitors directed by a single common supplier or other trading partner. A well-known recent example is Apple’s orchestration of a cartel among publishers to force Amazon, Apple’s competitor, to raise its ebook prices. In the franchise cases, the franchisor is the “hub” and the individual franchisees are the spokes.

At that point, the question is: What kind of evidence is required? Formally, these agreements are vertical—that is, between the franchisor on one side and each individual franchisee on the other.  A rule that requires evidence of explicit horizontal communication and assent among the franchisees, as the Sherman Act agreement provision does, would very likely preclude liability in many cases. A better approach here is structural: these agreements arise only because they are satisfying the wish of individual franchisees to be free of competition, not because they give effect to a franchisor’s policy of encouraging optimal employee performance through a system of promotion to new opportunities. As a result, the mere fact that such vertical agreements exist and reach down even to relatively unskilled employees should be sufficient to create a presumption that they are horizontal and thus unlawful. At that point, the franchisor or franchisees should have the burden to prove that the agreements actually achieve a more beneficial purpose.

For some courts, this “structural” approach may reach too far, at least when there is no good evidence that the noncompete originated from discussions among the franchises. This makes intra-franchise noncompetes a good candidate for the Federal Trade Commission, whose prohibition of “unfair methods of competition” can reach cartel-like activity when there is no good evidence of an agreement. The FTC Act cannot be enforced by private parties, so this would place the burden on the FTC. However, effective FTC enforcement or rulemaking could go a long way toward ending the effects of these pernicious arrangements that strike hardest at low-wage workers.

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