Berkeley Program in Law and Economics

Client relationships create value, which employees may try to wrest from their employers by setting up their own firms. Firms counter by inducing workers to sign contracts that prohibit them from competing or soliciting former clients in the event of termination of employment. Society trades off higher effort by self employed workers against the cost of establishing redundant businesses, and local governments compete to attract clients. If clients, firms, and workers can renegotiate restrictive employment contracts and make compensating transfers, the socially optimal level of entrepreneurship will be achieved regardless of government policies regarding enforcement of these contracts. If workers cannot finance transfers to firms, however, firms and workers will sign contracts that are too restrictive and produce too little entrepreneurship, and governments can increase welfare by limiting enforcement of these contracts. With or without liquidity constraints, more entrepreneurial locations will attract more clients and have higher employment and output.