Tipping and path dependency

A little while ago I was listening to a Freakonomics podcast1 about the economics and behavioral incentives of tipping. Tipping is pretty ubiquitous in American restaurants, with somewhere around 18-20% generally expected. But the entire ecosystem around tipping is a bit screwy. Because they are expected to receive compensation through tips, servers in most states are exempt from minimum wage laws, so their hourly pay can be quite bad. It’s also often discriminatory, with (for example) white servers typically receiving higher tips than black servers. There’s also some decent evidence that despite the theoretical alignment of incentives, the quality of service doesn’t tend to improve in response to potential tips (nor do people’s typical tipping amounts vary in response to quality of service).

Given all that, it makes sense that some restaurants might want to experiment with alternate forms of compensation, like simply raising menu prices, hiking pay for waitstaff, and doing away with tips. The podcast covered restaurateur Danny Meyer’s attempt to do just that – with pretty mixed results. The higher menu prices seemed to put off some customers, who viewed the restaurant as more expensive. More interestingly, staff turnover became significantly higher among front of the house staff – with as much as 30-40% turnover following the conversion to a no-tip model.

This strikes me as a classic coordination problem. If every restaurant got rid of tipping, waitstaff would likely be better off with higher, more stable wages. If only one does, that restaurant ends up with higher menu prices and more turnover. Also worth noting – the multiple equilibria in the coordination game. This isn’t the only way the coordination game could have resolved. The American tipping model is totally different from most other places in the world. If we never started tipping in the first place, wages could be more stable and higher across the board. In that case, if one restaurant suddenly cut server wages, lowered prices, and asked their customers to make up the difference, I bet they’d have a hard time staying in business.

There’s a couple conclusions to draw here. First, I don’t think we spend enough time thinking about the path dependency of decisions we make. It’d be great if restaurants had higher wages across the board – but at some point in the past, American restaurants decided to have tipping. Now it’s hard to change. This happens in other venues too. I think it’d be great if the American healthcare market looked more like the Swiss system.2 At some point in the past, though, we adopted employer-provided health insurance. Now that’s very hard to change. Anytime you face a coordination problem with multiple equilibria, it’ll be hard in the future to jump from one equilibrium to another. It’ll usually take some sort of shock to the whole system to make that sort of move.

Another conclusion – public policy is very important in these multiequilibria environments. Those shocks to the system have to come from somewhere. For restaurants, the easiest path towards the no-tip environment is likely for states to repeal minimum wage exemptions.3 Don’t discount the importance of external actors in helping to shock you from one equilibrium to another.4