An Economic and Pedagogical Defense of Gratuities.

Author:Gill, Anthony
  1. Introduction

    A new trend is sweeping the restaurant industry. It isn't the latest India pale ale or avocado toast. Nor is it a novel way to make reservations with a smartphone. Rather, it is a movement to eliminate the reliance on gratuities as a partial form of compensation for waitstaff. Instead, some establishments now rely on a fixed "living wage." Restaurants such as Ivar's Salmon House in Seattle, Bar Marco in Pittsburgh, Chez Panisse in Berkeley, and more than a dozen of Danny Meyer's sit-down restaurants in New York City have jumped on the "no gratuities" bandwagon (Tu 2015; Terenzio 2015; Erbentraut 2015; Passy 2014). Besides the ostensible concern for the waitstaff's financial well-being, other reasons restaurateurs have given for this policy change include customer preference (Erbentraut 2015); avoiding the managerial hassle of dividing gratuities among other workers in the establishment (Passy 2014); happier employees (Terenzio 2015); and even concerns over mitigating sexism and racism (Terenzio 2015). Journalistic accounts of restaurants implementing such a policy usually champion how this new practice has supported the business's financial health, though no systematic empirical study of successes and failures has been conducted to date.

    Gratuities aren't just unpleasant for a small set of restaurant owners seeking a better model for compensating waitstaff; they've also been historically unpopular with customers. Cultural historian Kerry Segrave has detailed attempts to eliminate the use of "vails" (tips) to reward servants as far back as the eighteenth century in Scotland and England, though rioting by those servants in London quickly ended that effort (1998, p. 2). Segrave further documents that in "Portland, Maine, in 1905, Mayor Baxter assailed the practice of college students receiving tips as waiters at summer hotels. Public reaction was said to be on the mayor's side" (1998, p. 1). And none other than labor leader Samuel Gompers decried the practice as "blackmail" (Segrave 1998, p. 7). (1) Today, opinion pieces rail against the inefficiency and injustice of gratuities as well (cf. Dunn 2013), and when presented with the option to eliminate tipping from various businesses, most students in my political economy course express support.

    But if the no-gratuity or fixed-labor-price model is preferred by a wide swathe of customers, makes employees better off, and enhances a restaurant's profit margin, the obvious question becomes, Why aren't more restaurants adopting this policy? Why does such a seemingly unpopular and inefficient practice as tipping persist? Surely markets would work to eliminate this norm if it was not efficient in an industry as competitive as restaurants. This puzzle presents an excellent opportunity to argue for the efficiency of gratuities, as well as to teach basic economic concepts in an environment that is familiar to most students, whether as restaurant workers themselves, as restaurant patrons, or both.

    This essay defends the longstanding practice of tipping in restaurants as an ingenious institutional mechanism for solving three common economic problems: the principal-agent problem; capturing gains from trade via price discrimination; and promoting the cultural trust necessary for anonymous exchange. (2) I argue that the use of gratuities is a win-win-win strategy for restaurant owners, customers, and high-quality employees. Owners benefit by solving the principal-agent problem that bedevils the service industry and by capturing diners who have lower reserve prices for the restaurant experience. Customers win by incentivizing higher-quality service on the margin. And, finally, gratuities act as a separating mechanism that allow high-quality employees to earn more than their low-quality counterparts while signaling to the latter that their talents lie elsewhere. And if poor-quality workers are filtered out of the labor pool, the restaurant industry (or sectors of it) benefits from a higher perception of amenable service. Finally, at the end of this essay, I make the case that teaching students about tipping is a fun and informative method for introducing esoteric economic concepts since nearly everyone in the classroom is familiar with this customary practice. Students who originate from foreign cultures that discourage this norm provide an interesting basis for comparative discussion.

  2. The Economic Logic of Tipping

    While suffering heavy critique from customers and social critics alike, the institutional persistence of gratuities demands an explanation. Reasons why people leave tips include feelings of fairness and equity, the desire for social approval, and concerns over future service (cf. Conlin, Lynn, and O'Donoghue 2003; Lynn and Grassman 1990). Most of this research focuses on the relationship between the customer and the server, asking why and how much customers tip. Tipping seems to undercut the basic logic of rational cost-benefit exchange in economics, as the custom almost exclusively occurs after a transaction has been agreed upon and carried out. A thinly rational individual who is unconcerned with reputational costs has a strong incentive to skip out, or defect from the norm, without any particular harm (cf. Lynn and Grassman 1990, p. 170). (3) For that reason, psychological explanations for tipping have tended to predominate in the limited literature on the subject. (4) Nonetheless, for three strictly economic reasons--two short term and one long term--tipping is economically rational for business owners, customers, and waitstaff: it solves principal-agent problems; it leverages price discrimination via the gains from trade to capture a broader clientele base; and it builds social trust through a ritualistic signaling mechanism to encourage anonymous trade. The last explanation relies less on "thin" accounts of rationality and dips into the literature on cultural norms, but such an argument can be squared with neoinstitutionalist theory when one accounts for efforts to alleviate uncertainty via the creation of institutionalized behaviors.

    1. The Principal-Agent Problem (5)

      The boss can't be everywhere. And when bosses are not around, employees have an opportunity and an incentive to shirk. This ubiquitous situation falls under the rubric of a principal-agent problem wherein the interests of an agent (employee) are not fully aligned with those of a principal (boss) who is trusting the agent to perform some duty on their behalf. It's not that the interests of the principal and agent are completely antithetical, but there is discordance between the two. A worker understands that their employment depends on the employer having a successful business and being able to retain and reward the employee, but all things being equal the employee would rather substitute leisure for labor (if paid a salary) or extend the amount of time fulfilling a task (if paid hourly). The trick to solving a principal-agent problem is to design some self-enforcing or policing mechanism that more tightly aligns the interests of the principal and the agent.

      The restaurant industry provides an example of the principal-agent problem at play. Diners patronize an eating establishment not only for the food served, but also for the ambience and service. A waiter who mistakes an order, fails to refill beverages, or has a cranky attitude can dampen the pleasure of a night out. But unlike food items, whose quality can be tangibly observed (e.g., proper temperature, appetizing appearance), service is more difficult to assess and is more variable in customer preference. Some diners enjoy attentive service from their waiter so as to catch a show, whereas others prefer to be left alone. A manager or owner could walk the floor to observe whether the waitstaff is performing adequately, but this would not be an efficient use of time.

      Enter gratuities. If tipping is a known practice among all diners, the customer becomes the policing mechanism for service quality and rewards it accordingly, freeing the manager to perform other tasks (e.g., ordering more cases of wine). Placing customers in partial control of the waiter's compensation also allows them to signal their desired form of service. To a manager on the restaurant floor, a waiter who is avoiding a table may appear to be giving poor service. However, if the diners at the table signal that they want to be left alone, a waiter who visits the table less frequently to refill water glasses might actually be doing an excellent job. High-quality servers identify patrons' cues and adjust their service accordingly. Customers are just as much the principals as the restaurant manager in this principal-agent scenario. By holding out the possibility of a generous tip at the end of the meal, those patrons can match their desired experience with what the waitstaff delivers. And, of course, repeat customers can signal their desire for a certain type of service by tipping generously with the expectation that their desires will be met in the future. Tipping is a win-win for both the employer and the customer, each of whom acts in the role of principal incentivizing the agent (waiter).

      Eliminating tipping in favor of a flat fee for service reduces customers' control over the pricing decision and exacerbates the principal-agent problem. Even if the waitstaff is paid a higher "living wage," which may arguably lead to happier employees and better service, the incentive to customize service for each patron is reduced. If waiters are paid the same amount to tend to different customers, there is less need to read or respond to the mood or preferences of those customers, and customers lose the opportunity to signal via subtle cues or outright communication. Given that checking on whether an order is ready, refilling water glasses, and clearing tables can be a hassle, an employee paid a flat rate will likely reduce this cost by shirking a bit.

      This is not...

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