Optimal Monitoring with External Incentives: The Case of Tipping

Abstract

1. IntroductionTipping 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). …