Signaling and Efficiency in Gift Exchange: An Application to Tipping

Abstract

In the gift exchange principal-agent game, other-regarding preferences are sufficient to support an efficient equilibrium with a strictly positive transfer. When the agent is uncertain about the altruism of the principal, however, he chooses a suboptimal level of effort to insure himself against unfair outcomes. I demonstrate that, under certain conditions, a relatively simple change to the structure of the game allows the principal to costlessly signal his type and restores efficiency. I argue that this result has implications for the design of gratuity-based service industries.