Competition, Innovation Incentives and No-Compete Clauses

Abstract

This paper sheds light on the changing nature of the firm and firm boundaries, and offers an explanation for why innovative, human capital intensive firms tend to operate in competitive environments. We develop a model in which employees' incentives to acquire human capital, a necessary input for innovation, depend on the number of firms competing for employee human capital. A key insight of our paper is that firms operating in the same industry have a higher degree of relatedness, since they invest in more compatible technologies. This implies that employees in more competitive industries develop human capital that can be transferred more easily from one firm to another and, thus, can extract more rents (i.e., greater wages) from their firms. Anticipating their higher rent extraction ability, employees invest more in human capital and innovate more. Thus, competition in the market for innovation promotes innovation. We show that, under certain conditions, firms prefer to operate in a competitive product market in order to become more innovative. In this way, competition emerges endogenously and leads to more innovation. We also show that horizontal mergers may be detrimental to innovation generation, and that firms may prefer to preserve a competitive environment in order to provide better incentives for their employees. Finally, our paper has implications for the choice of industry standards, such as open source technologies, and the adoption of contractual measures that hinder employee mobility, such as no-compete clauses.