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CONTENT

1. Introduction 2

2. Background

2.1 Tip Credit: A Brief History 6

2.2 Fair Minimum Wage Act 8

3. Literature Review

3.1 Tipped Minimum Wage Effects on Employment and Earnings 15

3.2 Tipped Minimum Wage Effects: Restaurant’s Choice between Tipping and Service Charge 18

4. Model of Firm’s Choice Between Tipping and Service Charge

4.1 Profit and Server Utility Function 22

4.2 Analysis of Propositions 24

4.3 Implications for Server Welfare in Restaurant Industry 35

4.4 Management Quality and Alternative Systems 36

5. Conclusion ` 37

References 38

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1. INTRODUCTION

Tipping is deemed a voluntary practice that involves the “gifting” of a sum of money to a

service worker for exceptional or quality service provided. The overall economic impact of

tipping within the US economy cannot be denied as it has become an “important economic

activity that in recent years has started to receive increased attention from economists” (Azar

2012). In the US food industry alone the annual amount paid in tips is estimated to be about $42

billion (Azar 2008). Tips are also common in over thirty service occupations and are carried out

in many countries. The Bureau of Labor Statistics records that there are currently three million

people in the United States working within these service industries who earn tips. For these

tipped employees, tips make up over 60% of their income and around 60% of them are paid

hourly rates with earnings below the federal minimum wage.

Although the federal government has not established a strict job classification structure

that defines which occupations are eligible to receive tips, the Bureau of Labor Statistics (BLS)

identifies a variety of industries and occupations most likely to have tipped employees. These

industries include restaurants, bars and casinos, hotels, automobile valet parking, local passenger

transportation, beauty salons and barber shops, passenger railroad services and deep sea

passenger services. The United States Department of Labor classifies tipped workers working in

these industries under the Fair Labor Standards Act (FLSA) as those employees who customarily

and regularly receive more than $30 per month in tips. Going forward in this Thesis, I shall use

the FLSA definition of a tipped worker to distinguish them from workers who receive less than

$30 per month in tips and other regular workers who only receive the regular minimum wage.

The motivation for my thesis stems from the prevalence of tipping in the restaurant

industry. According to the Bureau Labor of Statistics (2007a), 11 million workers are employed

in food preparation and serving-related occupations. Of this number, 498,090 are bartenders and

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2.357,040 are waiters and waitresses. For waiters and waitresses, tips are a major and often the

main source of income. However, due to the volatility of tips, these servers must also rely on

their employer to pay them a direct wage. Restaurant owners determine how much to pay their

tipped servers based off the federal (state) minimum wage and the federal (state) tip credit

policies. As a result of these policies, restaurant servers normally earn a lower minimum wage

which they combine with their tips to equal at least the applicable minimum wage (state or

federal depending on which one is more favorable to the employee).

In 1966, Congress added restaurant tipped employees to the FLSA (Fair Labor Standards

Act) and created the concept of the “Tip Credit”. The tip credit allows employers in most states

to meet their main wage obligation by having a certain amount of tips count toward the

applicable minimum wage and may be exercised by businesses with gross sales exceeding

$500,000 per year (only those engaged in intrastate commerce). It means servers receive a

special, tipped minimum wage that is lower than the full applicable minimum wage. This special

tipped minimum wage (federal $2.13) plus servers’ tips (tip credit) minus a tip pool (sharing tips

amongst other employees), must equal or exceed the full applicable state or federal minimum

wage. There are currently 34 states that have tip credit policies, 26 of which differ from the

federal policy. As stated earlier, the applicable tip credit policy depends on which one is more

favorable to the tipped worker. In most states, servers are subject to a state tip credit policy more

favorable than the federal and earn a higher tipped minimum wage. For the purpose of this

Thesis, I will be using “tipped worker”, “waiter” and “server” interchangeably.

In as much as I am motivated by the potential effects of tip credit policies on restaurant

server employment and earnings, my interest lie in restaurant management decisions. A relevant

theoretical study carried out by Azar (2008) argues that increasing the tipped minimum wage

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might lead restaurant owners to change from tipping to service charges. A service charge differs

from tipping in that it is a fixed percentage of the bill that customers mandatorily pay

(percentages may differ based on party sizes). In his theoretical model, Azar shows that servers

are better off within the tipping regime because they enjoy economic rents from receiving tips

and that a higher tipped minimum wage would decrease their welfare as the owner switched to a

service charge regime. I argue that an increase in the federal tipped minimum wage could cause

restaurant owners to choose a service charge regime in lieu of tipping. By closely analyzing

Azar’s (2008) theoretical model I hope to demonstrate the optimal conditions under which a

restaurant owner would switch regimes given an increase in the tipped minimum wage.

. The logic behind my argument lies in the economic motivations of the tip credit. It is

possible that restaurant owners implement a tip credit not only to minimize their wage obligation

to tipped servers but to also reduce the amount of economic rents enjoyed by servers in tips.

Servers or waiters enjoy relatively high income compared to their non-tipped co-workers

(dishwashers, cooks and janitors) and normally earn above their reservation wages which allows

them to enjoy economic rents. The issues that arise from this wage difference between tipped

servers (categorized as front-of-the-house-staff) and cooks for instance (categorized as back-of-

the-house-staff) are manifold and important for discussion but are beyond the scope of this

thesis. However, I will also comment on these wage differences as a small part of my analysis to

show hypothetical conditions in which restaurant owners may choose a service charge regime as

a means to close the wage gap between tipped and non-tipped workers.

Raising the tipped minimum wage (by reducing the tip credit) of these servers will enable

them to enjoy higher economic rents. In turn restaurant owners will try to remove these rents by

replacing tipping with a service charge. My interest in this area is further fueled by the newly

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introduced Fair Minimum Wage Act. This policy will no doubt have an appreciable effect on

restaurant server earnings. The primary aim of the policy is to raise the tipped minimum wage

from $2.13 to $4.90 by the year 2016. Furthermore, with an intended increase in the federal

minimum wage to $10.10, the policy will further increase the federal tipped minimum wage to

70% of the new federal minimum. This allows for tipped-workers to be entitled to a tipped

minimum wage of $7.07. In the restaurant industry profit margins are known to be historically

narrow and an increase in the tipped minimum wage would only narrow this margin further.

Restaurants typically have a profit margin of 5 percent after covering for all its operating costs

and overhead. Total costs to a restaurant tend to make up 90-95 percent of the total revenue

sales. Food and labor costs make up the majority of the costs at 50 percent whereas the

remaining 45 percent are spread between the restaurants fixed costs, maintenance costs and

utilities. Smaller costs come from supplies, fees and licenses, marketing and publicity and other

costs (Restaurant Industry Perspectives 2010). Therefore, a rise in the tipped minimum wage as

promised by the Fair Minimum Wage Act would provide the impetus for a firm to choose a

service charge regime.

As aforementioned I will be carrying out a close analysis of Azar’s model of a firm’s

choice between service tipping and service charge (2008) by looking at the motivations behind

its construction, applied economic logic and methodology. As such, I will begin in Section 2 by

providing background on the laws governing tip credit policies and the history of the tipped

minimum wage so as to shed light on the relationship between restaurant owners and servers. In

Section 3 I will discuss the relevant literature on tip credit policies and how they have affected

restaurant management decisions. In the second part of this section, I will discuss the pros and

cons of both the tipping and service charge regime with the intention of showing how a service

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charge regime is simpler to implement and maintain. Section 4 will be divided into two

subsections: 4.1 will be my analysis of Azar’s model of firm’s choice between tipping and

service charge and 4.2 will look at the potential consequences for the restaurant industry under

different regimes. For section 4.2 I will be discussing the questions “How would implementing

the service charge throughout the restaurant industry affect the restaurant labor market?” and “Is

there an alternative to the service charge regime that could also extract economic rents from

servers?” Section 5 will end with concluding remarks and suggest questions that could provide

for future thesis topics.

2. BACKGROUND

The implications of replacing tipping with a service charge cannot be fully understood

unless one understands the history of tip credit and tipped minimum wage policies and their

effects on the restaurant industry. This Section will begin with a history of the tip credit and how

it is currently implemented in the restaurant industry. Also will be discussed is the historical role

that lobbyists (such as the National Restaurant Association) played in influencing tip credit

policies and how the Fair Minimum Wage Act was birthed.

2.1 Tip Credit: A Brief History

Under federal law (and in most states) employers may pay tipped employees less than the

minimum wage, as long as these employees receive enough in tips to make up the difference.

This is difference is called a tip credit. The concept of a tip credit allows employers to credit an

employee's tips to satisfy the federal minimum wage requirement. Currently all workers,

regularly covered under Section 6(a)(1) of the FLSA, except for designated sub-minimum wage

workers and persons with disabilities, must be paid at least the federal minimum wage. Where

the worker is tipped (earning in excess of $30 per month in tips), he or she must receive at least

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$2.13 per hour directly from the employer, even when the earnings of the tipped employee may

be substantially in excess of the minimum wage. The current federal tip credit allows employers

to claim up to $5.12 of employees’ tips as part of their minimum wage obligations (over 50% of

the federal minimum wage). This leaves a tipped minimum wage of $2.13 paid to tipped

workers. If, however, an employee's tips combined with the employer's direct wages of at least

$2.13 an hour do not equal the federal minimum wage, the employer must make up the

difference. Some states have minimum wage laws specific to tipped employees. Therefore when

an employee is subject to both the federal and state wage laws, the employee is entitled to the

provisions which provide the greater benefits. Although most states allow employers to take a tip

credit, some don't, including California, Minnesota, and Oregon. In these states, tipped

employees earn both the minimum wage and tips.

Since the inception of the tip credit in 1966 (FLSA), there has been ongoing debate on tip

credit legislation by restaurant businesses putting pressure to increase the tip credit and workers

trying to reduce it. It is important to note that tipped minimum wage policies are of major

importance in those states that allow a tip credit to offset the employer’s minimum wage

obligations. Currently, 34 states practice some sort of tip credit policy. From the restaurant

businesses’ perspective having a tip credit in place ensures that they can exploit the benefit of

tips to offset their wage cost obligations. Their initial argument was that since employers create

the conditions that enable tipped employees to earn tips, employers should be allowed to

financially benefit from some of the tips their employees receive from customers. A further

supporting argument is that money saved from the tip credit is used to pay a normal living wage

to the back-of-the-house-staff who comprise of cooks, dishwashers and janitors. However, a

prevalent problem in the restaurant industry involves restaurants that take the tip credit but also

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require their tipped employees to share their tips with the back-of-the-house-staff, thus reducing

their earnings further. While this practice is illegal and violates the provisions of the Fair Labor

Standards Act, it is widespread among restaurants. Despite the FLSA protections and the

possible availability of alternative jobs, most servers choose to stay and work in the restaurant

industry even when their legal wage entitlements are violated. This could be due to a number of

factors such as the lack of a worker Union representation to uphold their rights and enhance their

working conditions, and the high search costs associated with those alternative jobs. However,

given the scope of this Thesis, this topic on the working conditions of tipped workers in the

restaurant industry would best suit a separate thesis study.

2.2 Fair Minimum Wage Act

The Fair Minimum Wage Act was passed by a Democratic Congress in 2007 legalizing a

nation-wide increase in both the federal regular and tipped minimum wage (“Raise The

Minimum Wage”). The Act which will increase the minimum wage in three steps (from $7.25 to

$10.10 per hour) will be indexed to inflation each year. In addition, the legislation will increase

the required cash wage for tipped workers in annual 85 cent increases, from the current $2.13 per

hour until the tipped minimum wage reaches 70 percent of the regular minimum wage. This

would more than double the tipped minimum wage and could have significant effects on

earnings and employment in the restaurant industry. The legislation is estimated to give as many

as 13 million workers a much needed pay raise after a decade stuck at $5.15 per hour and

according to nationwide polls (National Journal Poll and Washington Poll) is supported by

approximately 66 percent of Americans and 61 percent of small businesses.

The National Restaurant Association (NRA) is the leading the business association for

the restaurant and foodservice industry which is currently made up of 980,000 restaurants and

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foodservice outlets and employs about 10 percent of the American workforce (13.1 million). In

response to the Fair Minimum Wage Act, the NRA has released numerous statements arguing

that the hurtful effects of the policy on restaurant business and ultimately on worker employment

outweigh the predicted benefits. In one of the many statements released on behalf of the NRA,

Representative Mel Sickler (owner of the New Jersey Auntie Anne’s Pretzels and Cinnabon),

argues (i) that the restaurant industry provides millions of workers with their first job and the

critical skills needed for a rewarding and successful career, (ii) that restaurants already laying off

workers as a result of state instituted minimum wage increases will only be forced to discharge

more workers and (iii) that tipped employees earning below the federal (state) minimum wage

have a higher national median wage as a result of earning tips and would only benefit further

from the wage increase at the expenses of the business. The National Restaurant Association

exercises considerable lobbying power as they are responsible for influencing the

implementation of the tip credit concept in 1966 and freezing the federal tipped minimum wage

at $2.13 in 1996 (which has not increased for 16 years). Historically, the tip credit was set at 50

percent. Since then, the rate has varied over the years, reaching its lowest at 40 percent in 1980.

Currently, the rate sits at 68 percent which is a testament to the lobbying power of the NRA. If

Congress were to restore the tipped worker minimum wage to its historic level of at least 50

percent of the federal minimum wage it would then have risen to $3.63 (Lynn 2014).

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Figure 1 A simple competitive labor market model illustrating the effects of imposing a minimum wage on worker employment.

Figure 1 illustrates the loss of employment across the nation due to an increase in the

federal minimum wage as argued would be the outcome by the NRA. W* represents the current

federal minimum wage firms are paying their workers. At this wage rate, the quantity of labor

demanded is in equilibrium with the quantity of labor supplied at L*. Opponents of the Fair

Minimum Wage Act argue that by raising the minimum wage to Wmin will raise labor costs of

firms and thus decrease their willingness to pay a worker’s marginal product at L* quantity to

LD. At the Wmin, more workers are incented to work and earn the higher marginal product

provided the by the firm and supply labor at quantity L3. However as the competitive labor

market is no longer in equilibrium, and the firm demands less than workers are supplying,

unemployment will increase.

Unemployed

Workers

Labor Supply

Labor Demand

LD L* LS Quantity of Workers

Wage

Wmin

W*

Perfectly Competitive Labor Market

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Figure 2: Illustration of Monopsony Equilibrium With Minimum Wage (BOLD LINE DENOTES MC(L) CURVE)

I argue that the labor market for the restaurant industry is monopsonistic for tipped

servers (Wessels, 1997). The effect of raising the tipped minimum wage increase the labor costs

of the restaurant. A particular restaurant possesses monopsony power if it has negligible

competition from other firms. As illustrated by Figure 2, this allows the firm to set a wage that

maximizes its profits at L* where the Marginal Cost of labor equals the Marginal Revenue

Product of Labor MC(L) = MRP(L). At this profit maximization level, the restaurant hires L*

quantity of workers and pays them a wage of W* which is below their MRP(L) wage of W. The

wage W is the regular minimum wage, but the restaurant pays its waiters the tipped minimum

wage W*. Unlike a competitive firm, a monopsony cannot hire as many waiters as it wants at a

constant wage due to a rising marginal cost of labor. It is the reason also that the restaurant will

not hire L** workers and pay them the competitive wage W**. To illustrate this point further, a

restaurant demands a given amount of waiters and is willing to pay them W* which is the tipped

Wage

Wmin

Marginal cost

(MC(L))

Supply (w(L))

Marginal revenue product (MRP(L))

L*

W*

Lmin Employment

F

E A

D C B

Monopsonistic Labor Market

W

L**

W**

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minimum wage (minimum wage W less tip credit). If the restaurant chooses to expand its waiter

capacity, it would have to raise the wage of its current waiters as well. The reasoning behind this

is simple. More waiters congest the serving floor in a restaurant to a point where average tips

decreases below the federal minimum wage. More servers mean fewer tips to go around.

As specified by the Fair Labor Standards Act, if a waiter does not earn enough hourly tips

to equal at least the hourly tip credit ($5.12), the restaurant owner must pay the difference (this

would mean lowering their claim on the tip credit). As more servers are employed and their

hourly tips fall below the tip servers will demand a higher compensation from the restaurant

owner. The higher compensation could come in the form of a higher tipped minimum wage

(reduction in the tip credit) or the portion of the tip credit not earned in tips. This is the

increasing marginal cost associated with hiring an additional server. Consequently the restaurant

owner chooses to hire servers at L* where the marginal cost of labor equals the marginal revenue

product of labor, instead of hiring at the socially optimal level L**. In a competitive labor

market, the restaurant will pay its servers their marginal revenue product (which is the socially

optimal level), however due to the existence of the tip credit policy, restaurants face a rising

marginal cost of labor and therefore find it optimal to pay their servers below their marginal

revenue product.

Also illustrated in Figure 2, the imposition of a higher tipped minimum wage would increase the

firm’s average cost of labor but reduce the marginal cost of labor. Absent a minimum wage, the

marginal cost of hiring the last waiter, at point A, lies above the wage paid by the restaurant due

to the fact that every waiter’s wage has to be raised in order to induce a marginal waiter to join

the firm. If the minimum wage is set above the monopsony equilibrium wage but below the

marginal cost of hiring a waiter, the new marginal cost of hiring a waiter falls from point A to

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point C (the new marginal cost of labor curve is BCDEF). The marginal cost of hiring an

additional waiter is constant at the minimum wage (BCD). Consequently, the restaurant must pay

all waiters at least the minimum wage, regardless of the employment level. Furthermore, the firm

does not have to increase the pay of its existing workforce to attract more employees, so long as

the employment is below Lmin. However beyond the Lmin the restaurant will once again face a

rising marginal cost (DEF) for every additional waiter it hires. The behavior displayed above in

the restaurant monopsonistic labor market contradicts the arguments of the National Restaurant

Association. that raising the tipped minimum wage will lead to unemployment. As long as

restaurant owners hire up until Lmin employment is increased and both old and new waiters will

be able to receive the new tipped minimum wage of Wmin and earn tips to keep them satisfied.

With every marginal server hired, the marginal revenue product to the restaurant falls

(this is also depicted by the downward sloping MRP(L) demand curve). This is due to congestion

as a result of limited (fixed) factor inputs such as floor space, amount of tables (serving stations).

As a result, these extra servers become inefficient and slow down the rate and quality of service.

Not only are the marginal tips falling as a result of more servers being hired but also the marginal

revenue product. In a monopsonistic labor market, the restaurant owner will pay the tipped

minimum wage for all levels of servers below Lmin. As Figure 2 illustrates, Lmin is the optimal

level of employment because it is the point where marginal cost of labor MC(L) = Wmin the new

tipped minimum wage. Beyond Lmin then MC(L) > Wmin indicating that marginal cost of labor is

increasing again with each additional hired worker.

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Figure 3 illustrates the potential problem a restaurant owner will face when expanding his firm’s

wait staff capacity. Increasing the volume of labor should coincide with an increase in output

(sales) and a higher demand from customers. However, a forced increase through an imposed

minimum wage (as is possible in restaurants displaying monopsonistic behavior) may cause the

firm to hire more tipped workers than it really needs, thus ultimately resulting in a higher

marginal cost and falling marginal product which leads to a decrease in total output (due to

decreasing marginal returns)1.

1 As floor space (fixed input) becomes congested waiters become inefficient in their service. Consequently they

provide less service and receive less tips.

L* Lmin L** Quantity of Labor

Figure 3: Illustration of the diminishing returns to labor. Lmin is the optimal level of labor

employment.

Marginal

Revenue Product

Increasing

Marginal Returns Negative Marginal

Returns

Diminishing

Marginal Returns

Law of Diminishing Returns to Labor

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3. LITERATURE REVIEW

An increasingly important area of study for many economists has been the magnitude and

implications of tipping and the tipped minimum wage in the restaurant industry on tipped worker

employment and earnings. Wessels (1993) examined empirically the implication of allowing

restaurants to institute a tip credit on its tipped servers and estimated that doing so would create

at least 360,000 new high paying jobs and increase total income of tipped workers by 8%. The

elimination of the tip credit would however reduce servers’ employment by 10%. In another

study, Wessels (1997) suggests the restaurant labor market is monopsonistic and that every

additional waiter hired would reduce the average amount of tips earned by each waiter.

Therefore each waiter would have to be paid a higher wage and over some range a higher tipped

minimum wage (lower tip credit) should increase servers’ employment. In light of these studies,

the author demonstrated how the implementing of a tip credit allows restaurant owners to hire

more servers therefore attesting to a positive implication of the policy. These studies support a

crucial element in my analysis of Azar’s model of the firm’s choice between service tipping and

service charges in that servers are better off working in a tipping regime due to (i) receiving

economic rents (excess of their reservation wage) in the form of tips (ii) the adoption of the tip

credit policy and the imposition of a tipped minimum wage which both increases the firm’s

willingness to hire more servers.

However, not all minimum wage and tip credit policies designed to boost the income of

servers are effective as concluded in Anderson and Bodvarsson’s findings (2005). They

examined empirically how the tipped minimum wage affects the total income of servers and

bartender by dividing the US states to five categories according to the state policy on minimum

wage and on tip credit compared to the federal policy. Their findings suggest that serves in states

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with a higher tipped minimum wage have no income advantage over servers elsewhere.

Therefore states with policies designed to boost the income of servers will find that they are

generally ineffective.

3.1 Tipped Minimum Wage Effects on Employment and Earnings

Several theoretical and empirical studies have examined the overall effects of raising the

tipped minimum wage in the restaurant industry. Even and Macpherson (2014) conducted an

empirical study on the theoretical effects of the Fair Minimum Wage Act on employment levels

and earnings of tipped servers in the restaurant industry. Furthermore they found that as federal

law increased minimum wage from $3.35 to $7.25 between 1990 and 2013, numerous states

were also passing laws increasing their minimum wage above the federal level thus resulting in a

substantial increase in the interstate variation in minimum wages.

They argued that if the labor market is competitive, an increase in the minimum wage

reduces employment of workers previously earning the minimum but can increase or decrease

aggregate earnings of the affected workers depending on the elasticity of labor demand. This

explanation makes intuitive sense and is further supported by Danziger (2007) who argues that in

the face of a downward sloping demand curve for labor, a minimum wage legislation that raises

workers’ wages above the competitive level will inevitably lead to job losses for some of the

workers. As depicted in Figure 4, imposing a minimum wage where the firm has an elastic labor

demand would lead to larger portion of the server population losing their jobs. On the other hand

if the labor market is monopsonistic, small increases in the minimum wage can increase both

employment and earnings of affected workers, but sufficiently large increases in the minimum

wage reduce employment.

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Figure 4: A simple competitive labor market model illustrating the effects of imposing a minimum wage whereby the labor

demand is elastic.

By extension of the competitive model, an increase in the tipped minimum wage (which

occurs simultaneously with a reduction in tip credit) would reduce the employment of workers

eligible for the tip credit and depending on the elasticity of labor demand, could either increase

or decrease total earnings in the industry. They further posited that an increase in the tipped

minimum wage could potentially lead to rents (wages in excess of reservation wages) for tipped

workers. Thus employers would work to offset the increased cost of a higher tipped minimum

through the following: First, by requiring tip pooling which would take some of the tips away

from the tipped workers and redistribute them to other workers. In this way, as more workers

share the tips, the employer can reduce their wages and offset the costs of the higher tipped

minimum wage while also denying the one tipped worker from retaining all of his economic rent.

Unemployed

Workers

Labor Supply

Labor Demand

LD L* LS Quantity of Workers

Wage

Wmin

W*

Perfectly Competitive Labor Market

18

Second, if tip pooling is not a viable option for offsetting the effect of a higher tipped

minimum wage, the employer could attempt to reduce the effect on labor costs by requiring each

server to perform more non-tipped work. The Fair Labor Standards Act also makes provisions

for tipped workers working two or more jobs when at least one of them is a non-tipped job. By

this provision, a restaurant waiter/server could be called in to perform other tasks such as

cleaning with the back of the house staff but would only be compensated the regular minimum

wage and not the tipped minimum wage plus tips. Third, Evan and Macpherson draw on

Wessels’ study (1997) who suggests that while restaurants may hire waiters in a competitive

labor market, an increase in the number of waiters in the restaurant industry [ceteris paribus]

reduces the amount of tips per hour because of the limited number of customers (ratio of waiters

increases to consumers) and must thus be offset by higher money wages to retain waiters. As a

result, in the absence of a minimum wage, the restaurant faces an upward sloping labor-supply

curve and displays monopsonistic behavior in response to a higher minimum wage. In

conclusion, increases in the tipper minimum wage could lead to an increase in employment

however a sufficiently large increase would reduce employment.

Other effects of raising the tipped minimum wage are explored by Anderson and

Bodvarsson (2005) who used 1999 earnings data on state-specific measures of hourly

compensation for waiters, waitresses and bartenders and found that after controlling for

economic conditions and worker characteristic, higher tipped minimum wages have no effect on

hourly compensation (wages plus tips) for these tipped workers. In contrast, Allegretto and

Filion (2011) found that servers living in states with a higher tipped minimum have higher

hourly wages that include tips. Therefore if states with higher earnings levels are more likely to

have tipped minimum wages above the federal level, a spurious relationship would be found

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between tipped and minimum wages and earnings. The difference in results of these separate

studies may have risen from the use of different data sources, and the lack of control for other

factors that might influence earnings and a state’s tipped minimum wage, as in the case of

Alegretto and Filion.

3.2 Tipped Minimum Wage Effects: Restaurant’s Choice between Tipping and Service Charge

A slight setback to my research was realizing how limited the literature was on the effects

of the tipped minimum wage and tip credit policies on a firm’s choice between tipping and

service charge. Two studies I was able to find and are central to my analysis are by Brown and

Rolle (1991) and Azar (2012). Brown and Rolle conducted their study to see of whether or not

the decision to switch from a tipping regime to a service charge depended on (i) the restaurant

type and (ii) whether or not the owner’s acknowledge the complications of the tipping regime

and would thus consider a simpler system such as a service charge regime. Based on survey

responses from 304 Iowa restaurants, Brown and Rolle found that restaurants with high sales

volumes generally favored staying with the tipping regime but were willing to switch to the

service charge as a means of price discrimination (imposing different service charge percentages

for banquets, party sizes and predetermined groups). Brown and Rolle hypothesized that

restaurant owners that (a) had a higher education level and (b) ran high sales volume restaurants

would agree that service charges are easier to implement and maintain as well as decrease the

wage disparity between tipped workers and non-tipped workers substantially. However, despite

the differences in the level of education of the restaurant owners, the restaurant’s volume of sale

and ratio of tipped to non-tipped employees, the owners’ responses to the opinion ratings

revealed that despite the complications of the tipping regime, they would prefer keeping and

perfecting it than switching to the service charge regime. Brown and Rolle’s study also revealed

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the determinants of restaurant tipping policy which is an important element of the tipping regime

that Azar (2012) incorporates into his theoretical model. The determinants are the Internal

Revenue Service (IRS), federal (state) laws governing tipped employees (combine at 46 percent)

and customer preference (44 percent).

Azar (2012) examined the theoretical effects of the minimum wage for tipped works on

firm strategy, employment and social welfare. It is his work and theoretical models that

motivates my study. In contrast to the aforementioned studies looking at increased employment

and earnings as a result of a tipped minimum wage hike, Azar argues that when faced with a

higher minimum wage, restaurant owners will offset the increases in wage costs by adopting a

service charge. Under the service regime, servers no longer receive tips as they will be paid the

regular minimum wage; in other words, they will be receiving just their reservation wage. He

further argues that customers will be informed of the regime change and will assume their tips

are accounted for in the service charge. As a result, all service charge fees are retained by the

owner. Azar states that such a regime change would allow the restaurant owners to extract all the

economic rents that were enjoyed by servers in the tipping regime thus reducing their social

welfare. His study focuses on four propositions each with their own set of assumptions and

policy combinations (all of which I will analyze in greater detail in Section 4). In his analysis,

Azar examines the theoretical implications a higher minimum wage (tipping regime), higher

supervision cost (service charge regime) and no minimum wage on a firm’s profits, waiter’s

utility and social welfare under both regimes. In Proposition 1 Azar states that a restaurant’s

decision to switch from either regime will depend on (i) which regime has the higher profits and

(ii) which ever of the two is higher: service charge or supervision costs. Proposition 2 states that

a switch from tipping to service charge will occur if the higher tipped minimum wage exceeds

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the maximum wage threshold (mc). Passed this threshold the restaurant will most likely decide

that it is more profitable to operate under a service charge regime. However the value of the

threshold (mc) may be positive or negative (the intuition behind this will be discussed further in

Section 4). Proposition 3 examines the firm’s choice between tipping and a service charge

compared with that of a social planner whose goal is to maximize social welfare. Azar

demonstrates in this Proposition the conditions under which regime (tipping or service charge)

achieves social welfare maximization. He further argues that the service charge regime would be

chosen by restaurants if it maximizes social welfare whereas it may or may not choose a tipping

regime if it does the same. Finally, Proposition 4 examines the extreme case in which no tipped

minimum wage exists and the restaurant is allowed to charge its workers for the right to work

and earn tips (negative wages). Azar argues in Proposition 4 that is the most socially-optimal

regime which the restaurant will always choose.

22

4. MODEL OF FIRM’S CHOICE BETWEEN TIPPING AND SERVICE CHARGE

4.1 Profit and Server Utility Function

For the purpose of my analysis of Azar’s model and the propositions he puts forward, I

will proceed by assisting the reader in understanding the rationale of the model by explaining its

theoretical framework. Azar constructs a profit function and waiter’s utility for both a tipping

regime and service charge regime. The main variables of interest such as the customer tips and

price of meals are a function of both the waiter’s effort (under a tipping regime) and the firm’s

effort (under a service charge regime)2.

(a) Tipping Regime

Azar posits that under a tipping regime tips and costs to the waiter are a function of the

waiters effort and are denoted as T(ew) and C(ew) respectively, with subscript w to indicate that it

is the waiter choosing his own level of effort. The waiter has an increasing marginal cost of

effort C’(ew) > 0 and C’’(ew) > 0 and if he exerts zero effort, his costs are zero C(0) = 0. The

waiter is also paid by the restaurant a wage of (wt) for each meal served and must at least equal

the tipped minimum wage per hour (m). The tipped minimum wage (m) is always positive (m) >

0, and is calculated on a per meal basis, i.e. by taking (m) and dividing it by the number of meals

on average served in an hour. Despite various studies arguing that restaurant tipping is a function

of many other exogenous variables other than service quality, Azar assumes that the customer

tips an amount T(ew) which is a function of the waiter’s effort and is normally considered the

case where tipping is the norm. For simplicity sake the marginal tip of effort is an increasing

function T’(ew) > 0 whereby the customer tips more when the waiter exerts more effort.

2 Azar presents a simple model that considers only one firm. Cost of effort to the waiter C(ew) is strictly positive and

increasing. Tips are a function of waiter’s effort level T(ew) but is weakly concave to effort due to T’(ew) ≤ 0

23

Furthermore, T’(ew) ≤ 0 to assume that the tipping function is weakly concave in effort (higher

effort results in higher tips but the marginal returns are non-increasing). A waiter’s utility under

the tipping regime (distinguished by subscript t) will thus be a function of tips earned, tipped

minimum wage and cost of exerting effort and will be written as an expression:

(1a) Ut = T(ew) + wt – C(ew)

Furthermore, the expression T(ew) – C(ew) ≥ U0 assumes that if the waiter receives only tips at

the effort level he chooses in equilibrium, the waiter will still have an incentive to keep his job.

This is due to the fact T(ew) provides the waiter economic rents which is in excess of their

reservation utility U0 (the minimum utility or the utility that would be received at the waiter’s

best alternative job). Azar assumes that because T’(ew) > 0, a waiter can exert higher effort and

expect to receive tips that would exceed his reservation wage.

The profits of the restaurant are a function of numerous variables, however Azar

disregards other restaurant costs such as food costs or the wages of non-tipped workers (as they

would normally remain unchanged under both regimes) to simplify the equation and make for

easier comparison between the tipping regime and service charge regime. First, under a tipping

regime, a customer is willing to pay the menu price P(ew) for the meal plus the waiter’s tips

T(ew). The sum of these two variables is the customer’s total willingness to pay the restaurant,

denoted as V(ew). Azar also assumes that the menu price P(ew) is a function of service quality,

and therefore by extension, the waiter’s effort. The assumption allows him to argue that marginal

price is increasing P’(ew) > 0: the higher the waiter’s effort (consequently also higher service

quality) increases the price paid to the restaurant. The profit function under the tipping regime

(distinguished by subscript t) is thus written as the following expression:

24

(1b) Πt = P(ew) – wt = V(ew) – T(ew) - wt

Note: V(ew) = P(ew) + T(ew). In addition, Azar assumes the restaurant chooses the menu price

exactly equal to the customer’s willingness to pay P(ew), therefore there is no consumer surplus.

(b) Service Charge Regime

Using a service charge instead of tipping makes several important differences. First, it is

a mandatory amount that does not depend on the waiter’s effort. Second, it goes to the owner of

the restaurant instead of the waiter. Third, as the tipping regime is cancelled, the restaurant

owner will have to pay his waiters (who previously received the tipped minimum wage) a

different wage that must equal at least the regular minimum wage to avoid violating minimum

wage laws. Finally, in the under a service charge regime, waiters no longer are incented to exert

a high effort, therefore the restaurant owner incurs a supervision cost (denoted as s) as he hires

staff to monitor the effort level. Azar assumes that due to this supervision, the restaurant owner

will implement his own effort level through the waiter, denoted as ef which will also be a cost to

the firm, C(ef). Under this regime, the profit function is thus:

(2a) Πs = P(ef) – ws - s = V(ef) – ws – s.(3)

It is also important to note that ws, the wage paid to the waiter under a service charge

regime must equal at least the waiter’s reservation utility, U0.4 Azar states this as the utility the

waiter receives from the best alternative job. Therefore it is the minimum utility the restaurant

must provide the waiter; otherwise he will quit and find another job. As such, under a service

charge regime, the restaurant owner will choose to pay the waiter a wage of ws = U0 + C(ef), no

3 Azar assumes for the purpose of his service charge profit function that supervision costs, s, are strictly positive.

4 The reservation utility equals the reservation wage, w, plus cost, c and is weakly lower than the waiter’s utility

under a tipping regime, i.e. T(ew) – C(ew) ≥ U0 = w + c

25

more and no less (as long as the wage provided is weakly higher than the minimum wage, U0 +

C(ef) ≥ m). The restaurant’s profit function under a service charge regime, and waiter’s utility are

thus written as:

(2b) Πs = P(ef) – U0 – C(ef) - s = V(ef) – U0 – C(ef) – s

(2c) Us = U0

Note: the waiter does not incur any cost to effort as is seen in the tipping regime because the firm

implements its own effort level, C(ef), and incurs and pays the cost.

4.2 Analysis of Propositions

Now that the theoretical framework of Azar’s profit and waiter utility functions has been

explained, I will state Azar’s first proposition and proceed to analyze its workings.

Proposition 1: “Let ef be the value of e (firm’s chosen effort level) where the

marginal revenue is equal to the marginal cost, V’(ef) = C’(ef). Also let

ew be the value of e (waiter’s chosen effort level) where the marginal

tip received is equal to the marginal cost to waiter’s effort, T’(ew) =

C’(ew). The service charge, denoted as sc, is defined as sc = V(ef) –

[V(ew) – T(ew)] – [U0 + C(ef) – m)”. (Azar 2012)

In Proposition 1, Azar demonstrates that the restaurant firm will choose a service charge

regime if (i) its profits are greater than that gained in a tipping regime and (ii) if the supervision

cost, s, of implementing a service charge regime is lower than the service charge gained. Azar

expresses this mathematically by comparing the two profit functions as shown by expression

(3a), and then by rearranging the terms, he derives the service charge function, sc =V(ef) – [V(ew)

– T(ew)] – [U0 + C(ef) – m] as shown in (3b):

(3a) Πs = V(ef) – U0 – C(ef) – s ≥ Πt = V(ew) – T(ew) – m

26

(3b) s ≤ sc = V(ef) – [V(ew) – T(ew)] – [U0 + C(ef) – m]

The purpose of expression (3b) is intended to display the restaurant firm’s choice

between the two regimes given the cost of supervision and profits. Azar further states that the

firm implements tipping if and only if the supervision costs incurred by implementing a service

charge regime are greater than the service charge received (s > sc). Consequently, by definition

of his model, if supervision costs exceed the service charge, the restaurant may benefit from a

tipping regime as it would make more profits. Furthermore, If s < sc (as is expressed in equation

(3a)) the firm chooses to implement a service charge regime, because the benefits of the service

charges to the restaurant outweigh the supervision costs.

The main argument presented in Proposition 1 is that profits in a service charge regime

will be higher than that in the tipping regime due to the firm implementing a higher effort level ef

> ew . The firm always has an incentive to exert a higher effort level to maximize profits and to

cover its wage obligations (m) and supervision costs (s). In contrast, a waiter can choose to exert

a higher effort but not as much as the firm because he only has to cover his C(ew) and is only

concerned with maximizing his utility, Ut. Therefore a restaurant firm will prefer a service

charge regime when profits are greater than the tipping regime: Πs = V(ef) – U0 – C(ef) – s > Πt

= V(ew) – T(ew) – m. Re-arranging the expression yields s ≤ V(ef) – [V(ew) – T(ew)] – [U0 + C(ef)

– m) or s ≤ sc, in which case the service charge exceeds the supervision costs and therefore the

restaurant benefits by switching to a service charge regime. Given this reasoning, a firm’s profits

under a service charge regime will be lower than a tipping regime’s if its supervision costs are

higher than its service charge.

The reasoning behind Proposition 1 makes intuitive sense, however, Azar’s profit model

under the tipping regime should include an additional variable that is tied directly to T(ew) + m.

27

This variable is the FICA (Federal Insurance Contributions Act) payroll tax that is 7.65 percent

of the waiter’s wages (m + T(ew) ). The restaurant owner would need to deduct the employee’s

7.65 percent and also pay the employer portion of the tax, also 7.65 percent (total FICA payroll

tax rate is 15.3 percent). The tax rate would be represented as a constant, σ, which decreases the

firm’s profit and waiter’s utility. Thus the profit model would be expressed as: Πt = V(ew) –

T(ew) – m – σ(T(ew) + m). σ(T(ew) + m) represents the employer’s portion of FICA tax rate. In

addition, the waiter must pay the tax through his wages and tips, T(ew) + m which will decrease

his utility further: Ut = T(ew) + m - σ(T(ew) + m) – C(ew). The inclusion of the tax variable

explains why many servers underreport their tip income. Furthermore, all restaurant owners

employing tipped workers are required to pay taxes on their wages (which include the tip

income).

FICA tax credit

The credit is equal to the employer-paid FICA taxes on income above the minimum hourly wage.

Federal rate Hours worked (Monthly) Tips (Monthly) Total Income

Tipped Minimum $2.13 40 $350 $435.20

Regular Minimum $5.15 40 nil $206

Income over minimum wage

$435.20 less $206 = $229.20 FICA tax credit $229.20 x 7.65% = $17.53

.Actual employer portion paid = $435.20 x 7.65% = $33.29 Actual employer portion paid (less) tax credit = $15.76

Figure 5 demonstrates how employers calculate their FICA tax credit after paying their

portion (7.65 percent) on the FICA taxes. A typical server works 40 hours a week and earns the

hourly tipped minimum wage at $2.13. In addition to this, he earns $350 in tips which brings his

total monthly income to $435.20. If he were earning the regular minimum wage of $7.25, his

Figure 5: Illustration of employers calculating their FICA tax credit.

Source: Katz, Sapper and Miller

28

total monthly income would just be $290. Therefore, because of the tips, the waiter is earning an

economic rent of $145.20. When the employer pays his portion, he is actually paying $33.29 in

FICA taxes on the server’s wages (which include his tips). However, when calculating for a tax

credit, the employer can only receive a credit on the portion of the income in excess of the

minimum wage. The minimum wage for calculating the tax credit is$5.15 instead of $7.25 due to

a provision in the Small Business Work Opportunity Act of 2007 which froze the minimum

wage at that rate. Therefore, the employer would only receive a credit of $17.53. However,

despite the existence of the tax credit, many restaurant owners find that it is too complicated to

submit a claim for. In addition, waiters and other tipped workers tend to underreport their tip

income which complicates the process even further. Wolf (35) adds that the IRS is authorized by

the Eleventh and Federal Circuit to collect taxes on unreported tip income from the employer

(without assessing the individual employee’s share of the tax). In 2000, the IRS successfully

collected $9 billion in unreported tips from employers. Since the tax paid on tips is an added cost

to the business, the restaurant owner may feel more inclined to switch to the service charge

regime.

Proposition 2: “Increasing the minimum wage, m, can increase, decrease or leave

without change the waiter’s utility. It also weakly decreases the firm’s

profits and social welfare.” (Azar 2012)

Azar’s second proposition defines the minimum wage threshold, mc. By rearranging the

combined profit functions of the restaurant firm, the minimum wage threshold is thus equal to:

(4a) mc ≡ s – V(ef) + V(ew) – T(ew) + U0 + C(ef).

The rearranged expression suggests that mc is equal to the supervision cost less the customer’s

total willingness to pay under a service charge regime and tipping regime, less the tips earned

plus the waiter’s wage under a service charge regime. Therefore, any increases in any of the

29

latter variables (holding s fixed) would yield a negative threshold,, mc ≤ 0. Likewise, an increase

in supervision costs, s, would yield a positive threshold, mc > 0. Azar assumes the value of mc

may be positive or negative and proceeds to explain the effect of raising the tipped minimum

wage from below or above the threshold on the restaurant firm’s decision to switch between the

two regimes. If the minimum threshold is negative mc ≤ 0 it follows then that the minimum wage

is greater than the threshold, m > mc (for m is always positive in this model) and therefore the

firm chooses to implement a service charge for any “non-negative minimum wage”. Likewise, if

mc > 0, it follows that the minimum wage is below the threshold and the firm would choose the

tipping regime. However, as long as the minimum wage is strictly below mc, that is, m ≥ mc

(otherwise it will choose to implement a service charge).

My analysis of Propositon 2 carries on with Azar’s calculation of the social welfare of

both regimes. Social welfare in his model is calculated as the sum of the firm’s profit and

waiter’s utility. For instance SWt = Πt + Ut = V(ew) – T(ew) – m + T(ew) + m – C(ew). For m <

mc, a tipping regime is implemented and the social welfare (denoted SWt) would equal to SWt =

V(ew) – C(ew) after cancelling out the other variables. Likewise, m > mc provides a social welfare

expression for a service charge regime (denoted SWS) expressed as SWs = V(ef) – C(ef) – s. Azar

demonstrates that when a restaurant faces an increasing tipped minimum wage, m, and if (m <

mc) the firm’s profits are decreasing in m and the waiter’s utility is increasing in m. However,

social welfare does not change because SWt = V(ew) – C(ew). On the other hand, when m > mc,

and the firm faces an increasing tipped minimum wage, it’s profits, waiter’s utility or social

welfare are unaffected, because the firm is operating in a service charge regime and is not paying

its waiters a wage of m (we recall that the waiter’s service charge regime wage is U0 + C(ef) ).

The following reasoning behind this would be that under a service charge regime the restaurant

30

owner is extracting the waiter’s economic rent, so it offsets the effect of paying the waiters wage

(U0 + C(ef) ≥ m).

Figure 6 is a graph constructed by Azar to illustrate the effects of a rising minimum wage

on the firm’s profits, waiter utility and social welfare. The graph shows tipping regime profits,

Πt, as decreasing and waiter’s utility Ut as increasing with an increase in the tipped minimum

wage, m. Upon reaching and exceeding the restaurant’s minimum wage threshold, mc, further

increases in the minimum wage have no effect on profits and waiter’s utility (and ultimately

social welfare, which is the sum of the two) due to the firm choosing a service charge regime.

5

Furthermore, Azar’s graph shows how overall social welfare is higher in the tipping

regime where the restaurant’s profits decreases as the waiter’s utility increases with a rising

tipped minimum wage. Passed the threshold mc, profits and waiter’s utility become unaffected

5 Figure 6 illustrates Azar’s model depicting the effect of an increase in minimum wage on the firm’s profits and

waiter’s utility. The effect is stronger below the threshold m < mc. Passed the threshold, mc < m, the effect is zero.

SWt

Πt

Ut SWs

Πs

Us = U0

m Tipping Service charge

Figure 6: The effect of the minimum wage on the equilibrium (Azar 2012)

mc

31

and summing their functions yield a lower social welfare level, SWs which is also unaffected by

further increases in the tipped minimum wage, m.

Returning to the monopsonistic labor market in Figure 2 (which I mentioned earlier in

Section 2), we can see how Azar’s model of firm’s choice between tipping and service charge

comes into effect given an increase in the tipped minimum wage. To recap, a federal or state

imposed minimum wage on the restaurant industry will enable restaurants to afford more waiters.

This is because the effect of the minimum wage (Wmin) flattens the marginal cost curve around

the region (BCD), therefore hiring an additional waiter does not induce a pay raise for the other

waiters. As long as the wage is above the monopsonistic equilibrium wage, W*, and below the

competitive wage W**, the restaurant firm will be able to pay the wage and hire more workers.

Figure 7 illustrates the effect of an imposed tipped minimum wage at the competitive wage W**.

Employment would rise to L** which is now the new Lmin. This according to Azar’s theory is the

minimum wage threshold mc. Any further increases in the tipped minimum wage beyond mc =

W** = new Wmin would be too expensive for the firm (employment would fall as a result and

workers social welfare is reduced). At this point the restaurant would decide to switch from a

tipping regime to a service charge regime. Another reason is that the new tipped minimum wage

forces the restaurant to hire more waiters than it really needs to operate a profitable business. As

mentioned earlier, limited factor inputs such as the floor space of the restaurant and number of

serving stations would become congested as a result of the influx of waiters. Consequently, tips

are also reduced, and the waiters will demand for the employer to make up for the lost tips

needed to reach the regular minimum wage level. Thus if the employer continues to hire waiters

(partly because of the imposed tipped minimum wage and partly because he wants to expand his

business) he will end up paying the regular minimum wage to each waiter to compensate for

32

their lost tips. Therefore it is more profitable for the business to implement a service charge

regime and control the amount of waiters it wishes to employ.

Figure 7: Illustration of Monopsony Equilibrium With Minimum Wage (BOLD LINE DENOTES MC(L) CURVE)

Proposition 3: “Social welfare is higher with tipping if and only if s > z ≡ V(ef) –

C(ef) – [V(ew) – C(ew)]. z is the welfare increase (recall SWs = V(ef) –

C(ef) – s; SWt = V(ew) – C(ew)). If supervision costs are greater than

the welfare increase a firm implements tipping. Furthermore the firm

implements tipping if and only if s > z – C(ew) + T(ew) – U0 + m.”

(Azar 2012)

Azar examines the likelihood of the restaurant firm choosing to switch regimes based on

how high or low its supervision costs are compared to its waiter’s economic rent (wages in

excess of the reservation utility U0) and the value of a social welfare increase (SWs – SWt). In

this expression, a higher supervision cost would mean that social welfare is higher with tipping.

Wage

Wmin = W**

Supply (w(L))

Marginal revenue product (MRP(L))

L*

W*

Lmin = L** Employment

F

E

A

D C

B

W

Marginal cost

(MC(L))

33

Likewise, a lower supervision cost, would mean social welfare is higher with a service charge.

Expressed as an equation yields:

(5a) s > z – C(ew) + T(ew) – U0 + m (social welfare higher with tipping)

(5b) s < z – C(ew) + T(ew) – U0 + m (social welfare higher with service charge)

Note: z is the value of the social welfare increase: SWs - SWt = z ≡ V(ef) – C(ef) – [V(ew) –

C(ew)]. More importantly, the economic rent is expressed as: T(ew) – C(ew) – U0 + m.

Proposition 3 (which is described graphically on the following page) examines the

conditions of social welfare maximization in which the restaurant owner would consider

switching from a tipping regime to a service charge regime. The regime that maximizes social

welfare is determined by the comparison between cost of supervision and its benefit, which is the

increased welfare due to a higher effort level, ef instead of ew (this welfare increase is also the

value of z). Azar argues that while it would be socially optimal to implement a tipping regime

between the regions z and z – C(ew) + T(ew) – U0 + m, the restaurant will still choose a service

charge regime because it can extract the waiter’s economic rent.

The economic rent is the difference between the waiter’s utility under a tipping regime

and his reservation utility and is thus equal to T(ew) – C(ew) – U0 + m. Figure 7 shows that at

lower levels of supervision (s<z) social welfare is higher and a service charge regime is

implemented. In contrast, higher levels of supervision (s > z – C(ew) + T(ew) – U0 + m > z) a

tipping regime is socially optimal and social welfare is maximized. In regions of intermediate

supervision costs, (z < s < z – C(ew) + T(ew) – U0 + m) the restaurant would rather implement a

service charge regime and extract the economic rents from the waiter then implement a tipping

regime.

34

Proposition 4: “If no minimum wage exists and the restaurant can charge its waiters

for the privilege to work and earn tips, this results in the social-optimal

regime is always being chosen by the restaurant.” (Azar 2012)

The final proposition sums up Azar’s study and suggests that social welfare is always

maximized by the restaurant’s choice to allow the restaurant to charge its workers for the right to

work and earn tips (negative wages). In this way the waiter’s economic rent under tipping is

eliminated. The restaurant extracts this economic rent by charging him T(ew) – C(ew) – U0. As

SWt

Ut

Πt

Πs

SWs

Us U0

z s

z-C(ew)+T(ew)-U0+m

A service charge is socially

optimally and implemented

Tipping is socially optimal but a

service charge is implemented

Tipping is socially optimal

and is implemented

Figure 8: The effect of the supervision cost. Solid lines are used for values in the equilibrium regime, i.e. for Πs, Us

and SWs when s ≤z – C(ew)+T(ew)-U0+m and for Πt, Ut and SWt when s > z – C(ew)+T(ew)-U0+m. Dashed lines are

used for values in the non-equilibrium reg (Azar 2012).

35

aforementioned, the wage thus earned is negative. Azar expresses this as wt = U0 – T(ew) + C(ew)

≤ 0. Due to minimum wage laws the restaurant cannot charge its waiter as much was it wants and

must pay them their reservation utility, U0. In addition the waiter’s utility would thus be equal to

their reservation utility: Ut=T(ew) + wt – C(ew) = U0. As long as the waiter is being paid a direct

wage equal at least their reservation utility, U0, and is working under a tipping regime, there will

always be opportunities to make economic rents. Therefore, a firm looking to increase their

profits should adopt a service charge regime.

4.3 Implications for Server Welfare in Restaurant Industry

As the Fair Minimum Wage Act comes into effect increasing the federal tipped minimum

wage, many restaurants in the industry will be faced with essentially two decisions: (i) switching

from a tipping regime to a service charge regime or (ii) finding alternative ways to extract or

reduce the economic rents enjoyed by tipped workers. Brown and Rolle’s (1991) study revealed

that restaurant owners appreciate the customer-monitoring that is reflected through tipping. In

addition, more than 80 percent of Americans prefer a tipping regime to a service charge.

However, issues arise when restaurant owners are required to pay payroll taxes, such as the

FICA tax, on tipped workers’ tip income and when tension arises between non-tipped workers

and tipped workers regarding pay disparities. Therefore, despite restaurant owners best efforts to

retain the tipping regime, there exists a high possibility that they will switch to a service charge

regime and endure the supervision costs associated with it.

As the Fair Minimum Wage Act and other tipped minimum wage policies come into

effect, there may be a gradual change in the restaurant industry in terms of restaurants switching

to a service charge regime (Azar, 2012). Consequently, waiters will lose out on their economic

36

rents as they no longer earn any tips but are paid just the regular minimum wage. Furthermore

customers will find that eating out at restaurants becomes an expensive exercise because service

charges are mandatory and can vary between different ranges of percentages of the bill. Azar

argued that the willingness of a customer to pay for a meal and its service is a function of the

waiter’s effort (tipping regime) or the firm’s effort (service charge). In addition, the firm places

its meal prices to equal exactly the customer’s willingness to pay P(e) thus guaranteeing no

consumer surplus. What restaurants might eventually face is a falling demand for their food if

they implement the service charge regime, although that remains to be seen.

4.4 Management Quality and Alternative Systems

A potential hindrance to a restaurant firm switching from a tipping regime to a service

charge regime may lie in the quality of supervisors it is able to hire and the structure and size of

the restaurant itself. In addition, many restaurants have successfully reduced the economic rents

of its waiters by (i) pool sharing arrangements and (ii) engaging the waiter and other tipped

workers in non-tipped jobs. The provisions of the FLSA only apply for tipped workers if they are

working tipped jobs. Therefore a waiter assisting with the dishwashers or cooks should be paid

the regular minimum wage and consequently, the employer should not add this non-tipped job

into his tip credit claim. A pool sharing arrangement is an effective extractor of economic rents

from the individual server as it requires the server receiving the tips to share with other tipped

workers (bussers and bartenders for instance). However, it is still ineffective in extracting those

rents and placing them as the owner’s property. Therefore, it appears that the most efficient and

effective system of extracting the waiters’ rents is through the service charge regime.

37

Anecdotal evidence for the influence of the tipped minimum wage on the restaurant’s

choice between tipping and a service charge is not widespread in the United States, however, a

restaurant owner in California (California pays tipped workers the full minimum wage) noticed

the tension growing between the waiters, who had little to no professional training, and cooks,

who spent years in training and earned much less than their tipped co-workers (Azar, 2012).

Furthermore, evidence from restaurants in other countries have switched to a service charge

regime as a result of a higher tipped minimum wage. In Israel, a court decision that ruled that

workers should be paid the minimum wage in addition to their tips, led to some restaurants

replacing tips with service charges.

A problem that may also arise from doing away with the tipping regime and adopting the

service charge regime lies in the effect on employment of tipped workers. Wessels (1993) argued

that with a tip credit policy, restaurant owners are able to afford hiring more tipped workers as

long as those workers are paid the tipped minimum wage and earn the rest of their wage in tips.

A service charge regime will pay its servers a regular minimum wage which could mean that it

will have to cut back on expanding its wait staff or laying off inefficient workers (Stigler 1946)

38

CONCLUSION

The National Restaurant Association has successfully lobbied to increase their tip credit

claim whilst freezing the federal tipped minimum wage at $2.13. The Fair Minimum Wage Act

has come to the rescue of the minimum-wage-earning population who have had to live on

stagnant wages for the past 23 years. While this is a welcome policy guaranteed to help many

tipped workers, the proposed rise in the tipped minimum wage (which is over 200 percent more

than the current wage) appears drastic and could end up hurting most workers during its

implementation period. Azar’s model shows that profits and supervision are important factors in

determining whether or not a firm will choose to switch to a service charge regime. It may

appear that the propose increased in the federal minimum wage and corresponding increase in

the tipped minimum wage will cause restaurant owners to consider making a choice. The

proposed incremental increases of 85 cents per year for the tipped minimum wage may be just

the breathing space restaurant owners need in order to consider their best profit maximizing and

social welfare maximizing options.

As stated earlier, the literature on tipping policies and its effects on employment and

restaurant strategies has just become a topic of increasing interest in the past two decades and

therefore is still limited in capacity. Most of the studies carried out by economists focus on the

determinants of tipping and regard the consumer behavior as a social phenomenon (Lynn 204;

Azar 246; Bodvarsson 188). Tipping affects millions of workers, not only in the United States,

but in many other countries. Understanding then the effect minimum wage laws have on firm

decisions is of utmost importance.

39

REFERENCES

Allegretto, Sylvia, and David Cooper. "Twenty-Three Years and Still Waiting for Change: Why

It's Time to Give Tipped Workers the Regular Minimum Wage. "Economic Policy

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change-tipped-minimum-wage/>.

Anderson, John E., and Örn B. Bodvarsson. "Do higher tipped minimum wages boost server

pay?" Applied Economics Letters 12.7 (2005) : 391-393. Print.

Anderson, John E., and Orn B. Bodvarsson. "Tax Evasion On Gratuities." Public Finance

Review 33.4 (2005) : 466-487. EconLit with Full Text. Web. 6 Oct. 2014.

Azar, Ofer H. "The Effect Of The Minimum Wage For Tipped Workers On Firm Strategy,

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