Trade Secrets, Firm-Specific Human Capital, and Optimal Contracting

Abstract

Trade secrets are innovations jointly produced by firms and employees that are generally not protected by patents. They are commonly protected within the framework of labor contracts, where an obligation of confidentiality is imposed upon the employee. Specifically this obligation applies to the employee even after he has left the employer for a period of time determined in the contract, known as a “cooling off” period. Often employees are prohibited not only from revealing trade secrets, but also from utilizing their specific human capital developed at the original place of employment in competitor firms during this period. Their specific human capital is in effect inseparable from the trade secret. Failure to protect the trade secret will result in its revelation and its becoming public and hence worthless for the innovator. The inability of an employee to reveal trade secrets and utilize his specific human capital after leaving his place of employment imposes costs and losses upon him. Some form of compensation will be paid for these contingent losses within the employment contract. Employers know that the longer the “cooling off” period imposed upon employees, the greater employees must be compensated for this in the contract. Longer “cooling off” periods thus cost the employer more, but also enable him to earn greater rents from the innovation itself. In this paper profit-maximizing periods of trade secret protection are derived, based on these two countervailing factors, and comparative statics exercises are performed. How the selection of profit-maximizing periods of trade secret protection when the incidence of resignation is itself affected by contract parameters and incentives is explored.