Optimal monitoring with external incentives: the case of tipping.

• Author: Azar, Ofer H.
• Position: Wages of restaurant workers

1. Introduction

   Tipping is a significant economic activity, and yet its economic implications have hardly been explored. Tips in U.S. restaurants alone are around $27 billion a year. (1) Obviously, adding tips in other establishments such as hotels and taxis, and in additional countries, results in a much higher figure. Millions of workers depend heavily on tip income. Wessels (1997), for example, reports that in the United States alone there are over two million people who are servers as their primary occupation, and the number may be 60% higher if we add those who are servers as a secondary occupation. He adds that tips represent 58% of servers' income in full-course restaurants and 61% in counters, and that these figures are likely to be understated because servers often underreport their tip income. Finally, tipping has become a source of income in many different occupations: Lynn, Zinkhan, and Harris (1993), for example, consider 33 service professions that are tipped.

   How has tipping become such a prevalent social norm? Who has an incentive to support it? Do firms benefit from tipping, and in what ways? I analyze the interaction between tipping, which can be thought of as buyer monitoring, and monitoring by the firm. The analysis suggests that by motivating workers to provide better service, tipping enables the firm to reduce its costly monitoring of workers and to increase the price it charges (because of the increased service quality). Therefore, tipping increases the profits of the firm, so firms have an incentive to support the tipping custom.

   While this article focuses on the case of tipping, (2) the theoretical model is applicable to additional examples in which workers face external incentives (incentives that are not provided by the firm). One such example is the satisfaction that workers derive from doing their job well, especially in jobs that require initiative and creativity. This satisfaction (often referred to as intrinsic motivation) motivates workers to excel even when they face no monetary incentives to do so.

   Another example is that of military pilots: Their future prospects and expected salaries as civil pilots later in life depend on their performance in the military, thus providing them additional incentives to do their job well beyond the incentives provided by the military. (3) Similarly, anyone who thinks he may change employers in the future (whether voluntarily or not) has an incentive to work well in order to be more attractive to the next employer. Potential employers receive information about previous performance of the candidate from various sources, such as letters of reference and items on the curriculum vitae. Consequently, current performance affects the candidate's reputation and his prospects with other employers, giving him incentives to work well that are not provided by the firm.

   The common theme in all the above examples is that the worker faces external incentives to do what the firm also wants to achieve. In the case of tipping, tips promote higher service quality, and the firm wants to encourage high service quality as well; similarly, self-fulfillment and satisfaction from being successful, or reputation building in order to improve one's value in the job market, motivate the worker to work harder, which is also what the firm wants.

   The existing literature about tipping is mostly empirical and includes two main types of studies. One type interviews customers when they leave a restaurant and tries to evaluate which variables affect the tip size (for example, whether food quality affects tips). Major contributions of this type include Bodvarsson and Gibson (1994, 1997). A second type of study asks waiters to behave in a certain way (for example, to touch the customer lightly or to write "Thank you!" on the bill) and records the effect of this behavior on tips, using a control group as a benchmark (see, for example, Crusco and Wetzel 1984). (4) A unique and interesting study about tipping is the experimental article of Ruffle (1998) in which participants in dictator and ultimatum games acted in a way that resembles tipping.

   The theoretical work on tipping started with the pioneering work of Ben-Zion and Karni (1977), who show that tipping is consistent with a selfish customer only for the case of a repeat customer. They suggest that, in order to explain why one-time customers tip, one should consider altruistic behavior and social norms, which are not included in their model. Jacob and Page (1980) suggest that optimal monitoring may involve monitoring by both the owner and the buyer who interacts with the monitored employee. Sisk and Gallick (1985) argue that tips ultimately protect the buyer from an unscrupulous seller (or his agent) when the brand-name mechanism for ensuring contractual performance is insufficient. Schwartz (1997) suggests that tipping can increase the firm's profits when it enables price discrimination between two consumer segments that differ in their demand functions and their propensity to tip. Ruffle (1999) presents a theoretical model about gift giving and discusses briefly how the model can be applied to tipping as well. Azar (2004a) presents a model of the evolution of social norms. When a norm is costly to follow and people do not derive benefits from following it, except for avoiding social disapproval, the norm erodes over time. Tip percentages, however, increased over the years, suggesting that people derive benefits from tipping, such as impressing others and improving their self-image as being generous and kind.

   In this article, I analyze the optimal choice of monitoring and incentives by the firm when the worker faces external incentives that encourage him to do what the firm also wants to achieve. The theoretical analysis suggests that firms benefit from higher sensitivity of tips to service quality because it enables them to reduce the cost of monitoring. This implies that firms should encourage customers to tip badly (or not at all) for bad service, rather than to always tip. In addition, as long as tips are positively correlated with service quality, firms benefit from the existence of tipping. This result is consistent with historical evidence that suggests that U.S. firms promoted the custom of tipping in the late 19th century, despite attempts of several consumer groups, and even workers, to abolish the custom (Segrave 1998; Azar 2004b). This result, however, also suggests that numerous European firms that replaced tips with service charges possibly made a costly mistake. I discuss, however, why this might not be a mistake after all. The model also implies that in countries in which tipping is not prevalent, for example in Japan, Australia, and the Scandinavian countries, firms may do better by trying to promote the custom of tipping.

   The previous discussion suggests that the main contributions of this article can be categorized as follows: First, it addresses the issue of optimal monitoring in the presence of external incentives. Tips, intrinsic motivation, and reputation building are a few examples of such incentives. Second, the article contributes to the literature about tipping, analyzing the relationship between tipping and monitoring by the firm. Finally, the article compares the theoretical predictions to the behavior of firms in the United States and Europe and offers a potential explanation to the puzzle regarding the choices of European firms.

2. The Model

   The game involves two players (a firm and a worker) and two stages. In the first stage, the firm chooses how intensely to monitor the waiter, which in turn determines also the incentives to provide good service that the waiter faces. In the second stage, the waiter chooses the service quality to provide, and then receives both his tip and the incentives from the firm according to the service quality chosen. The tip is potentially increasing with the service quality provided. This may follow from the social norm being that better service should be rewarded by a higher tip. Alternatively, it may follow from the customer trying to discipline the waiter in a repeated-interaction scenario: The customer gives better tips for better service in order to motivate the waiter to give good service in future encounters. The task that the waiter has to perform is to serve a single customer. Serving a table of four can be considered as having four identical tasks; the effort and incentives are simply four times those for serving a single customer. I assume for simplicity that the bill size per customer is constant.

   Service Quality

   Let us denote service quality by s and define s = 0 to be the service quality that minimizes the waiter's effort. The assumption that such quality exists follows from the observation that below some quality level, reducing quality is in fact costly for the waiter. For example, being too slow and bringing the food cold may result in a requirement to heat the food, which causes the waiter more effort than bringing the food hot in the first place. Similarly, being rude may be more costly than just being unfriendly.

   Since service quality has no natural scale, we can scale it as we wish. I choose to scale it in a way that makes the tip linear with service quality. (5) That is, choose s = 1 to represent an arbitrary quality level that is better than s = 0. Denote the tip left for s = 0 as [T.sub.0] and the tip left for s = 1 as [T.sub.0] + T. Now define s = 2 to be the quality level that results in a tip of [T.sub.0] + 2T and so on. As a result, the tip is linear with service quality. Let [T.sub.0] + sT be the tip in dollars given for service quality s, where [T.sub.0] [greater than or equal to] 0 and T [greater than or equal to] 0. (6)

   The Firm

   Monitoring by the firm provides incentives for the waiter to give good service, in addition to the incentives provided by tips. The firm can punish bad service by dismissing the waiter or giving him...