In Defense of Tipping, Part II: Price Discrimination

In my previous article, I defended the much-maligned norm of tipping as an ingenious method of solving principal-agent problems. Gratuities incentivize good customized service when an employee can’t be monitored effectively.

In this installment, I argue that tipping is a form of price discrimination that benefits employers, employees, and customers. 

What Is Price Discrimination?

Although the term “discrimination” has negative connotations, the word basically means that individuals have different preferences and must make trade-offs, a fundamental economic concept.

The idea of price discrimination assumes that different people prefer to pay different prices for similar things. This is reflected in what economists call “reserve (or reservation) prices.” A consumer’s reserve price is the highest amount she is willing to pay for some good or service. For instance, I may be willing to purchase a coffee for up to, but not more than, five dollars. I would gladly pay less than five dollars, but $5.00 is my reserve price. 

Reserve prices vary across consumers. Some people relish coffee and devote more of their personal income to its purchase. Other people couldn’t be enticed to drink a cup of joe if you paid them. Reserve prices do not just vary across individuals; they frequently change for the same individual depending on context. I am more likely to pay a high price for coffee when I need a jolt in the morning than in the evening when caffeine would prevent me from sleeping. 

Consumers are not the only people with reserve prices. Sellers have them too. A seller’s reserve price represents the lowest cost a supplier is willing to trade for a good or service. A café owner needs to purchase java beans, brewing equipment, and other inputs (including labor) to make coffee. If those costs add up to $2.00 per cup, the café owner’s reserve price will be, at a minimum, two dollars. We might expect it to be a few cents higher so they can turn a profit. Of course, the vendor would happily accept anything above $2.00. If a profligate millionaire with a high reserve buy price offered $350 for a cup of coffee, the seller would happily accept.

When consumer and supplier reserve prices overlap, gains from trade can accrue. In Figure 1, we see that Customer A will pay up to $5.00 for coffee. The café owner has a reserve sell price of $2.00, the minimum he will accept. The gains from trade (or surplus) represents the difference between these two reserve prices – i.e., $3.00. Of course, the customer would prefer to pay only $2.00 for the coffee and capture the three dollars of the (consumer) surplus generated. The owner would rather charge $5.00 and keep the $3.00 (producer) surplus for himself. Anywhere between the reserve buy and sell price, trade can occur. The question merely becomes how the surplus is divided between the two.

Note that in Figure 1, Customer B has a reserve buy price slightly above the café owner’s reserve sell price. If the owner offers coffee at $5.00 to capture all of the surplus from A, he will lose B’s business. That isn’t much of a problem if the owner knows his clientele is exclusively those like Customer A, willing to pay $5.00. 

Unfortunately, sellers often do not know who their potential customers are and what reserve prices they have. Given that any individual’s reserve price can change based on context, pricing a good or service becomes a complicated guessing game. Customer A may buy coffee at $5 on Tuesday morning, but wouldn’t think of going above $2.50 on a lazy Saturday. 

Ideally, the seller prefers to charge each customer their highest reserve price, but gathering information about every customer in every context is costly. Businesses that rely on quick and multiple sales prefer to use menu (i.e., fixed) pricing to limit the time spent negotiating each sale based upon different consumer preferences. This is why we pay fixed prices in grocery stores but willingly spend time negotiating the gains from trade on infrequent, expensive items (e.g., automobiles).

Enter price discrimination. 

Sellers often devise “tricks” to discriminate between customers who have different reserve prices, and charge them accordingly. The café owner may price coffee at $3.50, but offer coupons to more cost-sensitive individuals. Restaurateurs know that retirees on a fixed income are more price sensitive and typically eat dinner earlier, thus they create senior discounts from 4:00 – 6:00 pm. Happy hours lure in budget-conscious consumers who are different from evening diners who gladly pay more for fine wine with their meal. Additionally, the smart seller will bundle different items together (e.g., a coffee and pastry special) to create different price points for varied consumers. See my article on the price of movie popcorn for an entertaining example.

This all may seem trivial, but it plays an important role in how tipping affects an entrepreneur’s business model.

Tipping and Price Discrimination

Unused table space is a restaurateur’s worst nightmare. Empty seats represent deadweight loss – excess space that is not generating revenue from paying customers. Moreover, restaurants that are not bustling with customers signal to potential diners that the food and service may not be good. (Smart hostesses will always seat customers near windows first to make the establishment appear popular to passerbys.) Finally, hoping all the tables fill to capacity, managers prefer to have more staff on shift to deal with a busy establishment. Understaffed restaurants have slower service and generate dissatisfied customers who do not return. However, if the manager overstaffs a shift and tables don’t fill, the crew ends up being paid to “stand around.” This is deadweight loss an owner seeks to avoid. Filling seats is critical.

To minimize such loss, restaurateurs attempt to keep costs as low as possible to entice customers who have lower reserve prices. (Note that high-end restaurants with expensive menus are typically smaller venues that don’t risk exposure to empty tables. The smaller venue reflects the smaller population of individuals with high reserve prices.)

Consider Figure 2.

Here we have five customers with different reserve prices. Customer A is a “big spender” with a high reserve price, the kind of person that restaurateurs love. Customer E is cheap and unfortunately will not spend the minimum the owner needs to make a profit. The other customers have varied reserve prices falling above the owner’s reserve sell price. While the restaurateur likely prefers diners similar to A, he cannot always guarantee this will be his clientele. As such, he still wants to attract these individuals with lower reserve prices. If everything was priced at Customer A’s reserve price, those other diners would not show up and there would be empty seats. Not good. The question is how to extract as much surplus from Big Spender A yet not chase away all the others.

As noted earlier, the restaurant may offer different products (e.g., “nibbler plates”) or alter prices by time of day. Alas, only so much can be done on the food and beverage side of the equation since those items come with fixed costs. 

Another critical input that can be varied, however, is service. Some diners are in a rush and prefer to have attentive wait staff that shuttle them quickly through their meal. Others like to linger, perhaps with a romantic date. And then there are customers who really don’t care about the service as long as the food is good. These different customers will likely have different reserve prices based upon the type of service they prefer. The question is how to capture the surplus from those varying reserve prices.

Enter tipping.

If the restaurateur can minimize overall dining costs by keeping the base wage rate for servers low, she will be able to attract customers with lower reserve prices. Tables will fill. (Of course, she probably would like only the big spenders, but one cannot predict this accurately, so the smart move is to price with cheaper customers in mind.)

But low wages do not attract skilled workers who can read customer signals and customize service according to specific demands. If, however. there is a generally accepted norm that the customer can voluntarily pay an additional 15-25 percent based upon how they value service and whether the service meets their expectations, employees can make up for lower fixed wages by the quality of service delivered. 

In essence, tipping is an ingenious system of voluntary price-discrimination wherein customers self-select the amount they willingly pay based upon a social norm prompting individuals to reward those who satisfy their expectations. People who value great service and receive it have a normative “social expectation” to pay generously for such service. Whereas most price discrimination is instigated from the side of the seller, tipping represents a cultural mechanism that obligates consumers to reveal their own preferences and share their consumer surplus with the supplier. It flips the burden of revealing preferences to the buyer. Amazing!

The ”tipping zone” (see Figure 2) is the difference between the reserve sell price and each individual customer’s reserve buy price. This is the additional amount of surplus that the customer might share with the restaurant employees. Good service means that diners will shift 20-25 percent of their consumer surplus over to the wait staff.

Of course, not everyone demands great service, thus some people will not tip generously. Nonetheless, if labor and overall costs of the dining experience are kept low, these folks will still come to the establishment and fill seats, which we noted is very, very important. The wait staff may not benefit as much from these “low tippers,” but at least the restaurant will remain busy and owner’s more willing to retain staff. This is a win-win for everyone involved, including customers.

The Problem with the No-Gratuities Model

What happens if restaurants decide to eliminate tipping and raise wages for wait staff? Several things, none of which may be beneficial to owners, employees, and even some consumers.

In Figure 3, we see a restaurant that eliminated tipping and raised staff wages. Given that wages will be a direct and fixed cost, the owner now has a higher reserve price (solid red line). The wage increase is indicated by the distance between the old reserve sell price (green dashed line) and the owner’s new reserve price. The distance between the old reserve price and new one is the wage increase for each server. So far, so good.

The next thing that happens is that some customers are priced out of the market as indicated by Customer D, who previously didn’t tip much and/or ordered off the bargain menu. These individuals can no longer enjoy a night out, thus poorer consumers bear the brunt of a policy aimed at providing some workers with higher wages. Customer C is at the margin of the new prices, and any little economic perturbation (e.g, rising gas prices) may push him into reducing his restaurant visits. 

Interestingly, it is the upscale customer who benefits most from the “no gratuities” policy. Whereas Big Spender A may have willingly tipped up to her reserve price (red dashed line), she now only has to pay the fixed menu price (solid red line). The wealthy may be getting the biggest bargain here.

Also note that another loser in this scenario is the wait staff. While they do have a higher, guaranteed base wage, they no longer earn more in tips. To the extent that a waiter may be serving customers A and B and very adept at providing superb service, they will not make as much in take home pay since those diners are not leaving extra money at the end of the meal. Indeed, this is one of the top complaints of Danny Meyer’s staff when he adopted a no gratuities model. Even though he provided a “living wage,” the best servers experience a net income loss. 

The final problem for both the employer and staff is that with more diners being priced out of the market, there are more empty tables. The owner loses because he experiences more deadweight loss and declining profits. And with fewer diners, you need fewer servers. The manager will likely reduce employee hours to keep prices to the consumer down. Ironically, although the wait staff may have a higher base wage, they may actually be working fewer hours to the point that their weekly take-home pay is less than what it was when their wages were lower. Indeed, this is exactly what happened when Seattle raised its minimum wage recently. A University of Washington study noted that service employers were reluctant to lay off staff, but they did reduce hours worked such that employees saw their monthly income decrease by roughly $74 despite a wage increase. It is difficult to tell workers to eat irony. 

And speaking of minimum wage, recent policy proposals to eliminate sub-minimum wage for tipped employees is likely to have a similar effect as getting rid of gratuities in restaurants. As owners will try to keep the overall price of a meal down, they are likely to eliminate tipping and/or patrons will start to shy away from eating out as the cost of a sit-down meal soars.

The bottom line is that moving away from a gratuities model has negative impacts on business owners, their staff, and some of their less well-off customers. Keeping gratuities and allowing individual customers to pay for service according to their own desires is a more beneficial policy.

A Mystery Remains.

While we have now addressed the principal-agent and price discrimination issues related to tipping, we are still left with one puzzle. Why would anybody ever leave a tip at a restaurant that they knew they would not return to? If individuals are utility-maximizers, it makes no sense to “leave money on the table” when they are not required by law to do so. Yet, people still tip.

We will address that mystery in our next installment. Stay tuned.

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