Say that people can be easily identified by characteristic C. Say that the average tip left by people of group C_A is smaller than !C_A with a wide variance in tipped amounts within each group. Let’s assume that the quality of service (two levels: high or low) is pro-rated by the expected tip amount. Let’s assume that the tip left by a customer is explained by the quality of service. And let’s also assume that the expected tip amount from C_A is low enough to motivate low-quality service. The tip is provided after the service. Assume no-repeat visitation. The optimal strategy for the customer is to not tip. But the service provider notices the departure from rationality from customers and serves accordingly. If the server had complete information about what each person would tip, then the service would be perfectly calibrated by the tipped amount. However, the server can only rely on crude surface cues, like C, and estimate the expected value of the tip. Given that, the optimal strategy for the server is to provide low-quality service to C_A, which would lead to a negative spiral.
Tipping Lemons: Market Failures in Tips