A recent report from the National Restaurant Association projects sales in United States restaurant industry to reach $799 billion in 2017. The industry will remain the second-largest private sector employer with approximately 14.7 million employees. There is a variety of available occupations within the restaurant industry, some earn hourly wages while others earn salaries. Servers, also known as waiters or waitresses, occupy an important role for the restaurant. They engage the customer directly by conducting functions necessary to be an effective intermediary between what the customer desires and the service or product the restaurant wishes to provide. Unsurprisingly, the customer usually desires food or drink, and the restaurant desires some form of profit. In the United States, an employer is only required to pay a server $2.13 an hour in direct wages if that amount plus the tips received equals at least the Federal minimum wage. This has not changed for 25 years. There is a general social custom for customers to tip an amount that reflects a percentage of the final bill. The motivation for customers voluntarily choosing to tip servers incorporates socially constructed rules and numerous psychological processes that range from perceived labor effort to consideration of future visits. What would be the effect of replacing the current tip policy with a policy that implements higher hourly wages for servers? Who are the winners and losers of such a policy shift, and which option is expected to generate the largest social benefit?

This is an important question because the industry is growing with an increasing number of employees . The number of full-time waiters and waitresses employed full-time has grown from 780,000 in 2001 to 949,000 in 2016.

 

The act of tipping is rather puzzling from an economic perspective because the customer is choosing to pay without any legally bound obligation to do so. From a restaurant’s perspective, this phenomena is favorable and is cost-effective because the presence of tips incentivizes excellent service without increasing costs associated with monitoring or encouraging workers. The measure of how much to tip is based on the bill, or the monetary value of the restaurant’s product or service, denoted by the prices the restaurant chooses to deploy. This can be interpreted as tips being calculated and determined by using a “flat tax” approach rather than using a perceived labor effort approach. This encourages waiters or waitresses to seek employment at establishments that charge relatively higher prices for their food and drinks, since it increases the tax base from which customers calculate their tips. A relatively higher supply of applications for serving positions in higher-priced restaurants compared to lower ones grants employers with higher prices the ability to choose servers of the best quality.

As mentioned before, tips are not solely determined as a percentage of the bill. Customers spend additional income beyond what they’re legally bound to for reasons associated with perception and anticipation of future encounters. There is wide variance in how customers perceive quality of service in the restaurant industry. For some, it is largely determined by the length of time it takes for the food to be delivered. For others, it may be how informative the server seems to be by explaining the details and characteristics about the restaurant’s products. This ambiguous concept is the central idea surrounding behavioral economics. Studies must use empirical data from sample populations in conducting their research since it is so difficult to objectively differentiate between good and poor service. In terms of food delivery service, Peter Kerr and Bruce Domazlicky found that the percentage of a tip decreases by 0.12% for every minute of delivery time allotted. They also found that minorities and the elderly tend to tip smaller amounts than do other groups. Another study by Ofer Azar found that tips are hardly affected by service quality, in that when service quality was perceived as low, tips were still left behind by customers. Currently, 15% is applied to the final bill to calculate a socially acceptable tip. Some argue that it should increase to 20%, since the consumer price index has continued to increase and the hourly wage for serving positions has remained at $2.13 an hour.

This is known as “tip creep”, or the gradual increase in the acceptable tip rate. Inflation is not cited as a reason for the “tip creep” because its effects are already incorporated in the price of the inputs used to make the products the restaurant provides, which is ultimately priced to make a profit. A fancy dinner in 1950 might have cost $50, and a gratuity rate of 15% would have produced a tip of $7.50. Today, a fancy dinner might cost $100, and a gratuity rate of 15% would produce a top of $15. So increases in prices due to inflation also inflate the dollar value of tips without changing the gratuity rate of 15%, yet the gratuity rate is slowly increasing.

In Europe, the socially acceptable tip rate is 5-10%. Tipping beyond this amount can be viewed as cultural ignorance. The disparity between these tip rates is due to the differences in hourly pay for servers. In Europe, servers receive a higher base wage than servers in the United States.

One reason for this may be due to customer’s ability to relate to those in serving positions. Since the number of full-time waiters and waitresses has been increasing, there may be an increase in those who are aware of the typical work conditions present in this occupation. This ability to personally understand and relate to the those participating in the serving industry may instill a form of empathy which translates to paying higher tips.

In analyzing the effects of tipping on social welfare, a study by Ofer Azar researched whether tipping has an effect on service quality or not. Although service quality was generally high in his study, the sensitivity of tips to service quality was so small that it is unlikely for tipping to be the reason for the high service quality. Which leads to the question surrounding which compensation policy has more of an effect on service quality.

Theoretically what would happen if customer’s tipped solely on service quality that was derived from perceived labor effort? Prices would not play a role in determining the monetary value of tips. If an act of bringing out a plate or refilling a glass of water was universally perceived as labor, then the amount of plates brought out or glasses refilled determined the tip amount. If this was the case, customers visiting lower priced restaurants would pay more in percentage terms in the form of tips. This would be beneficial for servers in these restaurants, and it should go without reminder that demand increases in the presence of lower prices. More people east in the lower price ranges. The number of tippers would increase, and the amount of tips would be calculable to some degree. This could pose a great positive externality for society.

An alternative policy concerning compensation for service workers in the restaurant industry includes raising their hourly wage. Some states have begun to implement this policy, eliminating the need for customers to tip. David Cooper of the Economic Policy Institute has openly state the effects of this policy change on poverty levels. Observations show that the poverty rate among tipped workers is dramatically lower than in the states where they’re getting $2.13 an hour as their base wage. Unfortunately this form of compensation structure can be unmanageable from a shareholder perspective. The labor costs associated with this policy illuminate new problems. Servers earn at least minimum wage and receive tips, and cooks only receive at least minimum wage. This creates a wage disparity that was previously not there before.

The increase is labor costs for restaurants would be reflected in increases in prices for provided goods. The benefit to the server is at the expense of the general public or customer base. If wages were raised high enough to adopt a no-tip policy, price would rise slightly higher as well. The difficulty in promoting this policy lies in the challenges faced in changing long-term social norms and habits. People are used to tipping and replacing personal control over compensating servers with objectively higher prices may not sit well with the citizens of the United States, where personal identity and choice reigns supreme and shall not be impeded upon.

Each policy has its advantages and disadvantages for interests of the server, the customer, and the restaurant. A lower hourly wage coupled with tips is advantageous for the restaurant and the customer. The restaurant does not have to pay for motivating servers and service quality is assumed to be high. The customer has the ability to not pay more than legally obliged although that is seen as socially irresponsible. Still, the autonomy present is favored by individuals, especially ones in America. Servers are hurt by this policy through lower base wages on average, and higher poverty levels. With an increasing population of people becoming servers in restaurants, it will not be long for this issue to come to light.

A higher base wage and a removal of the tipping mechanism for servers in restaurants is favorable to the servers, but unfavorable for customers and restaurant stake-holders. Under this policy prescription, the fraction of full-time servers below the poverty level decreases, and a specific level of wages can be expected which directly affects consumption smoothing patterns. This could be advantageous to other plyers in the marketplace, who may see an increase in consistent demand. The restaurant, who historically already faces a slim profit margin, does not like this policy. They will have to append more money to maintain the processes that were in place before the policy prescription. Furthermore, customers may not like the idea of not being able to tip after a meal. This takes consumer power away and places it within the price of the food they buy. Whether or not this adversely affects demand is unknown. Plus, it will be difficult to reshape a firm social construct that has existed between customers and servers in restaurants for decades.

 

 

The Economics of Gratuity: An Evaluation of Different Compensation Policies in the Serving Industry

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