Friday, November 14, 2014

The Economics of Tipping

By Kenneth A. Zahringer
My dinner companion sounded indignant. “It’s a shame we have to tip the waitress,” she said. “The restaurant owner ought to pay the staff enough to live on.”
I imagine that is a common attitude among those steeped in our current cultural climate of envy and dislike of economic success — the anti-capitalist mentality, as Mises put it. It’s easy to fall into the trap of thinking that we tip waiters out of sympathy, due to their misfortune of having to work in an industry full of greedy restaurant owners who won’t pay a “living wage.” In fact, tipping is an elegant
market solution to a particular set of circumstances, often present in service jobs, that makes determining an appropriate wage extremely problematic. The practice of tipping used to be more common, applying to many more service positions than at present, when it is largely restricted to waitstaff and skycaps. Part of the reason for its partial demise is just the wandering course of economic change, but many jobs that used to be paid primarily by tips came to be covered by minimum wage legislation and simply disappeared.
So why do we tip? At first glance it seems rather odd that a waiter should be paid by two different people — employer and customer — for the same job. But in fact we, as tipping customers, are paying for a very different aspect of the waiter’s job than is the employer. The restaurant owner needs a way to get the customer’s order to the kitchen and the food out to the customer. Most anyone who can walk a straight line and operate a pencil can perform that task. But the restaurant owner also wants happy customers, and customers are happy when they have a waiter who can solve problems, handle special requests, and generally make their meal a pleasant experience, and that is a special skill set indeed. Coordinating these two different, and not closely connected, aspects of the job is what tipping is all about.
Information Asymmetry
The employer wants happy customers, but he has a twofold information problem. As a practical matter it is difficult for him to observe interactions between waitstaff and customers. In addition, the customers’ expectations regarding the quality of service are impossible to observe. This is further complicated by the fact that staff members are heterogeneous; they are different in terms of skill levels, personalities, and other characteristics that affect the customer’s experience of quality service. Thus the employer doesn’t have the information he needs to arrive at an appropriate wage for each member of his staff. The customer, however, is a participant in these interactions and as such has as complete information as is humanly possible. If the customer pays the server directly for that aspect of the job, the decision of the appropriate pay is made by the person with the most information about job performance.
Incentive Alignment
Employers generally want their employees to give their best, and presumably are willing to pay for that. However, the aforementioned information problem inhibits his ability to do so. Ideally, tips make the server’s compensation directly proportional and immediately responsive to the quality of service provided. This aligns the employee’s incentives with the employer’s; both now want to provide high-quality service to the customer, each for their own benefit.
Risk Sharing
Hiring a new employee entails risk. For the new employee, there is the risk that the job may not turn out as he had hoped. It could turn out to be a dead end with no future, or unsatisfactory in innumerable other ways. The employer, however, has a financial risk. The new employee’s skill set is unknown to the employer to at least some degree, regardless of how thorough the interview process might be. There is even more uncertainty with an inexperienced new hire; there is no history for the employer to work from. The employer has to pay the agreed upon wage, and if the new employee doesn’t perform as hoped he is losing money. If the new employee accepts a lower guaranteed wage and makes part of his compensation contingent on performance — the tip — this relieves risk in two ways. First, the employer is more willing to take a chance on a young, inexperienced worker. If the wage is lower, the minimum performance level needed to make the employee worth the wage is also lower. Second, since the employee can increase his earnings directly and immediately by improving his performance the job is not so much of a dead end. The low paying job becomes a valuable stepping stone, allowing the young, inexperienced employee to learn job skills, establish a performance record, and move on to something better. (It should be obvious that minimum wage legislation short-circuits this entire arrangement, making the employer much less willing to hire someone unless he is certain they are worth the higher wage. This is how lower-skilled individuals get shut out of the job market. But that’s the subject ofanother essay.)
That is the magic of the market. Even mundane habits like leaving a tip for a waiter play an important role in social cooperation and coordination. It is an elegant solution to a knowledge problem, developed spontaneously through the actions of a myriad of market participants. When left alone, people are pretty darn resourceful.
The above originally appeared at


  1. Having worked as a waiter in the past, I can say that this very accurately sums up the essence of the job- providing a great experience.

    Just last night, I had dinner at a new restaurant in town. There was one waiter attempting to handle the entire place (about 8-10 tables)! Further, he was terrible! Yes, he penciled down our order correctly (although he couldn't remember who ordered what- failing on 4/4 attempts to deliver each person their plate), but his demeanor was unexciting, even though you could almost see the gerbil frantically scurrying on its wheel inside his head by the expression on his face.

    The only thing that could (and did) match the mundane and mediocre service was the insipid fare. This "food" was so texturally poor and bland as to send one into an amazing fit of salting and peppering, perhaps even sprinkling a bit of water on in a futile attempt to breath some sort of life into it!

    The minimum wage for wait staff around here is over $9/hr., and the service they provide (in general) is lackluster- especially compared to other places I have lived where the wage is much lower. It is difficult for me to calculate what an appropriate tip is in light of the high wage the employer is paying and the lower quality service this creates. Although the food quality is typically outstanding at my local restaurants, the prices are quite high- no doubt a product of paying that person the higher wage.

    I very much wish to reward the server for an excellent experience, and don't wish to offend someone who I am dining with (not to mention the server) by leaving a substandard tip, but, enough is enough! I don't feel a server making $9/hr.+ should be compensated via tips to the point where they are making $25/hr. when they don't deserve it, but are being rewarded out of pity! I am sure that if the minimum wage for wait staff was $0/hr., there would be plenty of waiters and waitresses, and the service they provided would be top notch!

  2. I'd worry less about tips and more about fraudulent flips:

    Morgan Stanley pushed murky China stock to market

    Morgan Stanley's private equity team and its stock analysts have reaffirmed their confidence in Tianhe's management since the company's reputation came under attack. But a two-month investigation by The Associated Press identified significant discrepancies in publicly accessible financial records and statements Tianhe made to investors, including questions about whether its chairman sold himself Tianhe's main assets while he was running a predecessor company owned by the Chinese government.

    The controversy surrounding Tianhe — and Morgan Stanley's role in bringing the company to global investors — carries special significance at a time when China's financial markets are rapidly opening to the world. In September, Alibababa Group Holding Ltd.'s $25 billion New York IPO set the record as the world's largest. And next week, for the first time, foreigners will be allowed to buy shares in the roughly $3.9 trillion of companies traded on the Shanghai Exchange. Even investors who don't seek such companies will likely end up owning shares in them through mutual and pension funds that seek to replicate returns of the broader market.
    Tianhe's financial filings indicate that one principal customer, Shanghai Xidatong International Trading Co. Ltd., has bought as much as $100 million in chemicals each year. Business data purchased by the AP said the company's annual revenues and expenses in 2012 were less than $6 million, and the company's net worth was $900,000 in the red at the end of 2012. Its chief executive, Zhang Silang, declined to answer questions from the AP. Shanghai Xidatong's registered office is an unoccupied room containing broken furniture and old mattresses in a dilapidated apartment building. It conducts its business out of a different office with signs for another chemical company.

    "It's one thing for a company's executive to make optimistic statements about growing revenue, but it's a real warning sign when management is making statements that don't appear to be consistent with reality," said Jay Ritter, a professor at the University of Florida's business school who studies global initial public offerings.

    Morgan Stanley declined to answer the AP's questions, but one of its managing directors, Homer Sun, said in September that the $65 billion investment bank's Asian private equity unit stands behind Tiahne. In their most recent publicly available research note, Morgan Stanley's investment analysts continue to recommend that investors bulk up on the stock, which they predict will double within a year.

    Doubts about Tianhe could have consequences broader than market losses for the pension funds and retail investors who owned shares worth hundreds of millions of dollars through Morgan Stanley's private equity arm and mutual funds managed by firms including Blackrock Inc. and The Vanguard Group Inc. Funds owned by both companies held Tianhe's stock as of the end of September.

    Trouble could be costly for the banks that took Tianhe to market: Morgan Stanley, Bank of America Merrill Lynch and UBS AG. Problems would embarrass Hong Kong regulators, who have recently threatened to impose criminal penalties on banks that fail to prevent IPO clients from misrepresenting matters to the public.