Wednesday, 24 May 2017

Three reasons why tipping is a bad idea

Tipping has been in the news this week. Matt Heath started it with this article on Sunday, but then Deputy Prime Minister (and former waitress) Paula Bennett chimed in, saying "Overall I think the service in New Zealand is good, I always tip for excellent service and encourage others to too if we want standards to continue to improve" (at least, according to this article - I didn't read her letter to the Herald myself). Bennett's comments have stirred a lot of media interest (see here and here and here, for example). Now, as the voice of reason, I give you three reasons why tipping is a bad idea.

First, it's not rational if it's not already a social convention. To see why, we need to go through a little bit of game theory (which is good revision for my ECON100 students, since we did game theory in class last week). Consider a sequential game with two players: (1) the server, who can choose to give average service, or good service; and (2) the customer, who can choose to tip, or not, and makes their choice after the service decision of the server has already been revealed. Let's say that the basic outcome (average service and no tip) leads to a zero payoff for both players. Let's also assume that if the server gives good service, that increases the payoff to the customer by +6 (units of utility, or satisfaction), but comes at a cost to the server of -2 (units of utility). Finally, let's assume that if the customer chooses to tip, that reduces their payoff by 5, and increases the server's payoff by 5. The game is laid out in tree form (extensive form) below.


To find the subgame perfect Nash equilibrium here, we can use backward induction (similar to the best response method we use in a simultaneous game). Essentially, we work out what the second player (the customer) will do first, and then use that to work out what the first player (the server) will do. In this case, if the server gives good service, then we are moving down the left branch of the tree. The best option for the customer in that case is not to tip (since a payoff of +6 is better than a payoff of +1). So, the server knows that if they give good service, the customer is better off not tipping. Now, if the server gives average service, then we are moving down the right branch of the tree. The best option for the customer in that case is not to tip (since a payoff of 0 is better than a payoff of -5). So, the server knows that if they give average service, the customer is better off not tipping. Notice that the customer is better off not tipping no matter what the server does - not tipping is a dominant strategy for the customer. So, the choice for the server is to give good service (and receive a payoff of -2) or to give average service (and receive a payoff of 0). Of course, they will give average service. The subgame perfect Nash equilibrium here is that the server gives average service, and the customer doesn't leave a tip.

However, that analysis assumes that this is a non-repeated game. We know that if games are repeated, the outcome may be able to move away from the Nash equilibrium to an outcome that is better for all players (notice that the combination of good service and tipping is better for both players). How do we get to this alternative outcome? It relies on cooperation between the two players, and cooperation requires trust. The server has to trust that the customer will tip them, before they will agree to give good service. Can they trust the customer? Only if they have developed a relationship with that customer, and in most hospitality situations it is unlikely that a customer will encounter the same server again in the future (unless they are a regular). So, no trust. No cooperation. No tipping, and no good service.

Which brings me to social convention. One way to ensure cooperation from the customer is to make tipping a social convention, which has some social penalty attached to it. If it is frowned upon not to tip the server, to the extent that it becomes costly (in terms of moral costs or social costs, not financial costs) not to tip, then that changes the game. Say that the moral cost of not tipping is -6 units to the customer (since everyone who sees them not tipping the server then thinks the customer is a douchebag). This changes the game to this:


Now, where is the subgame perfect Nash equilibrium? If the server gives good service, the customer will tip (because +1 is better than 0). If the server gives average service, the customer will tip (because -5 is better than -6). Notice that tipping is now a dominant strategy for the customer. Knowing what the customer will do, the server will choose to give good service (since +3 is better than 0). The subgame perfect Nash equilibrium is now that the server gives good service, and the customer leaves a tip.

But it relies on a social convention, which is not the current convention in New Zealand. And developing new social conventions is not easy (although perhaps Paula Bennett is willing to give it a try in this case?).

The second reason why tipping is a bad idea is because of second-order effects. If customers have to tip the servers, this increases the cost of their meal. Since we know that demand curves are downward sloping, an increase in price will lead to lower quantity demanded - customers will demand fewer restaurant meals. If you doubt this point, then consider how many people you know (I'm sure there are at least some) who object to paying a surcharge for a meal on a public holiday, and so choose to either eat somewhere else (where there is no surcharge) or not to go out at all. Now, note that tipping is essentially the same as applying a surcharge to every restaurant meal.

Since the quantity of restaurant meals demanded will decrease, the number of servers required by restaurants also decreases. Tipping will make some servers better off (higher take-home pay), but will make others worse off (they no longer have a job). This has the same effect as raising the minimum wage, except the customers are paying the extra, rather than the employers. I'm not sure that's a trade-off that customers should be willing to accept.

The third reason why tipping is a bad idea is because it could be considered a form of corruption. If you doubt that, consider this example. Remember that the purpose of tipping is to reward the recipient for giving good service. Now, say that I'm pulled over by a police officer for driving through a stop sign, but the officer decides to let me off with a warning (seems unlikely, but let's run with it). The officer gave me good service - should I tip them?

The World Bank defines corruption as:
...the offering, giving, receiving or soliciting, directly or indirectly, anything of value to influence improperly the actions of another party.
Isn't tipping to reward good service providing something of value (money) to influence the actions of another party (to give you good service)? We could quibble over whether the influence is improper or not, I guess. But the general point is valid.

Anyway, now you have three reasons to use to explain why you shouldn't be tipping: (1) it's not rational (when there is no social convention for tipping); (2) it may make some servers worse off; and (3) it may be corrupt. You're welcome.

Tuesday, 23 May 2017

Update: Uber is starting to price discriminate

Last year I wrote a post about Uber and price discrimination. At the time, Uber was arguing that they don't adjust their surge pricing to take advantage of people whose phone battery is low. Here's what I wrote then:
So, should we believe that Uber is not price discriminating? Price discrimination increases profits when firms can do it effectively. This only requires three conditions to be met:
1. Different groups of customers (a group could be made up of one individual) who have different price elasticities of demand (different sensitivity to price changes);
 2. You need to be able to deduce which customers belong to which groups (so that they get charged the correct price); and
3. No transfers between the groups (since you don't want the low-price group re-selling to the high-price group).
The first condition is clearly met, and presumably Uber's app knows when the phone is low battery (it's probably buried in the terms and conditions for the app, which almost no one reads). Since customers don't know the battery status of other Uber customers, then the third condition is likely to be met too. So, if Uber isn't price discriminating on the basis of battery level, they are leaving potential profits on the table. Uber shareholders probably wouldn't be too happy to learn this. So, I think it's hard to believe that Uber don't take a lot of information about their passengers (including potentially the remaining battery life of their phone) into account at least at some level - perhaps they are not price discriminating via the surge price (i.e. the multiple by which they increase prices), but via the underlying base price?
Now, it seems that Uber is moving to use price discrimination more broadly. This New Zealand Herald story today notes:
Imagine you live in Sydney's lavish suburb of Bondi, while your friend lives in one the city's lower socio-economic regions.
You both order an Uber home at the same time, with each ride having identical demand, traffic and distance travelled.
Yet, you are charged significantly more for the service because of where you are travelling.
This could soon be a reality with Uber introducing "route-based pricing" — a new fixed rate fare system for its UberX service that charges customers based on what it predicts they would be willing to pay.
There is more on this story here, and here. In this case, those travelling to a richer area of the city may have less elastic demand for the ride (because the fare will take up a lower proportion of their income) compared with those travelling to a poorer area of the city. So, the optimal mark-up (of price over cost) is greater for fares to richer areas than to poorer areas, and the price discriminating firm will charge a higher price for those travelling to the richer areas.

Is it possible that this bit from the story might be both true and false at the same time?:
While this might sound like the service is separating its customers based on income, Uber's head of product Daniel Graf said this wasn't the case.
"This is not personalised. This has nothing to do with the individual," he told Business Insider.
Technically, Uber aren't separating customers based on income (because they don't know the customers' incomes). But they are separating based on route, and some routes are clearly more popular with higher-income customers (and that is why it is effective to price discriminate). The prices may not be personalised, in the sense that every person pays a difference price for the same route in the same market conditions, but it isn't a big step from third-degree price discrimination (group pricing, which is what they are currently doing) and first-degree price discrimination (personalised pricing, where every customer pays a different price, based on their own willingness-to-pay for the service). Uber can gather lots of information on their customers' past behaviour, including which fare prices they were willing to pay (or not) in the past, and use that for pricing in the future.

Price discrimination is not illegal or even unfair in many cases (this is a point I have made before). However, this is definitely an unfolding story that it would pay to keep an eye on.

[HT: Marginal Revolution, for the additional sources on this story]

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Monday, 22 May 2017

Fresh water is not a public good

The title to this post is deliberately provocative, but also entirely accurate. Fresh water has been in the news quite a bit recently, including this article by Kirsty Johnston in the New Zealand Herald today. Johnston writes:
Currently, common law dictates that naturally-flowing freshwater is treated as a public good, or that "no one owns the water".
By definition, a public good is a good that is non-rival (where one person using them doesn’t reduce the amount of the good that is available for everyone else) and non-excludable (where the goods are available to everyone if they are available to anyone). It is the first of these that is clearly not true for fresh water, and this should be clear from the first three paragraphs of Johnston's article:
It was the summer of 1983 when Poroti Springs first ran dry. The watercress stopped growing, the eels disappeared and the koura died, unable to survive as their habitat turned to dust.
Local hapu, the kaitiaki of the sacred Northland springs, were dismayed at the near-extinction of its mauri, or life-force, and the loss of their traditional food source.
The culprit? The Whangarei City Council, who, unable to get to the springhead because it was on Maori land, had drilled directly into the aquifer upstream and sucked up so much water for the town supply, the seemingly endless flow ran out.
Whangarei City Council drew water from the aquifer, and that left less water available further downstream - fresh water is a rival good, not a non-rival good. Goods that are rival and non-excludable are common resources. They are vulnerable to the Tragedy of the Commons, a problem that was first described by William Forster Lloyd in 1833, but was brought to modern attention by Garrett Hardin's 1968 article of that title published in the journal Science.

The problem with fresh water is that all users together (as a group) have an incentive to reduce the amount of water drawn from an aquifer (so that it doesn't run dry). However, no individual user has an incentive to reduce the amount of water they draw by themselves, because the cost of their action is spread over all the water users.

The first problem with the current regime is that many water catchments are clearly over-allocated, or else they wouldn't run dry. Over-allocation of water also has negative consequences for water quality.

One solution for common resources is to make them excludable, i.e. making them not available to everyone. That's what the water usage permits that regional councils issue under the Resource Management Act are designed to achieve. However, giving the permits away for nothing (or next to nothing) is clearly crazy. Johnston writes:
Figures obtained by the Herald found there are now 73 companies with consent to take up to 23 billion litres a year, for an average annual fee of just $200 each.
On a volume basis, that works out at one third of a cent per cubic metres of water (1000 litres). In comparison, an Auckland ratepayer is charged $1.40 per cubic litre [sic] by council, with the rest of the country paying anywhere from 70 cents to $3 to tap into their local supply.
That is ridiculous. Water in all uses should be priced the same. Otherwise, the allocation of water is bound to be inefficient, which is the second problem with the current regime. Although, I will point out that the cost of water drawn at the source (such as by a bottling company or an irrigation scheme) should be less than the cost of water at an urban home or business, because of the cost of the infrastructure (and other costs) associated with getting the water from the source to the home or business. But I very much doubt that the difference in cost is as much as a factor of 200 or more as in the paragraph quoted above.

The lack of a consistent price is not the only reason that the current regime is inefficient. The regional councils' permits create a property right over fresh water, which I wrote about in a post last June. To be efficient though, a property rights scheme has to have four key properties. The rights must be: (1) universal; (2) exclusive; (3) transferable; and (4) enforceable. Here's what I wrote in that earlier post:
Universality means that all fresh water use would need to be included in the system (so municipal water supply, irrigation schemes, industrial use, etc. would all have to have permits to extract and use water). There can be few exceptions to this - although hydro power (where the water is not used up or degraded - that is, its use is not rival, as it doesn't deprive others of also using the same water) may be one.
Exclusivity means that all of the benefits and costs associated with extracting and using the water must accrue to the permit-holder. This essentially means that there can be no free riders - no one benefiting from water who does not have a permit to extract and use that water.
Transferability means that the permits can be freely traded voluntarily. So, if you have a permit to extract and use water from a given river, and you find someone else who is willing to pay more for that permit than whatever you value it at (presumably, whatever value it provides to you), then you should be able to sell (or lease out) your permit. This ensures that water will be used in the highest value activities, and means that water has a price (representing by the price of the permits). Failing to sell (or lease out) a permit entails an opportunity cost (foregone income for the permit holder), so selling (or leasing out) a permit to someone else might actually be the best use of the permit.
The problem with the system that regional councils run is that the permits are not transferable - they can't be sold to those who are willing to pay the most for them. Notice that we've gone full circle now - if the permits were freely transferable, then the price of permits would be set in the market for permits, and all users would face the same price for permitted water allocation.

Fresh water may not be a public good, but it is in the public interest to get this right.

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Sunday, 21 May 2017

Book Review: The Climate Casino

My last book review (Merchants of Doubt) noted my surprise at those authors' comments about William Nordhaus. As I said then, I've gone on to now read Nordhaus's book "The Climate Casino", and as I suspected, Nordhaus is far from one of the 'bad guys' when it comes to evaluating the impacts of climate change, and what should be done to reduce the impacts.

Nordhaus explicitly notes that his work has been misinterpreted by some of the critics of climate change policy (notably this 2012 piece by "sixteen scientists" in the Wall Street Journal - ungated version here). That article says:
A recent study of a wide variety of policy options by Yale economist William Nordhaus showed that nearly the highest benefit-to-cost ratio is achieved for a policy that allows 50 more years of economic growth unimpeded by green house gas controls... And it is likely that more CO2 and the modest warming that may come with it will be an overall benefit to the planet.
In response, Nordhaus notes in his book:
The major point, however, is that the sixteen scientists' summary of the economic analysis is incorrect. My research, along with that of virtually all other economic modelers, shows that acting now rather than waiting 50 years has substantial net benefits... Waiting is not only economically costly but will also make the transition much more costly when it eventually takes place.
Interestingly, other than that point Nordhaus ignores the misinterpretation of his work by Oreskes and Conway in Merchants of Doubt, although he does cite their book. Where does Nordhaus stand overall on climate change? In the concluding chapter he notes:
A fair verdict would find that there is clear and convincing evidence that the planet is warming; that unless strong steps are taken, the earth will experience a warming greater than it has seen for more than a half million years; that the consequences of the changes will be costly for human societies and grave for many unmanaged earth systems; and that the balance of risks indicates that immediate action should be taken to slow and eventually halt emissions of CO2 and other greenhouse gases...
There are no grounds for objective parties simply to ignore the basic results, to call them a hoax, or to argue that we need another half century before we act. 
The book is divided into five main sections, essentially covering: (1) climate data and the evidence for climate change; (2) the impacts of climate change on human and other living systems; (3) strategies for slowing climate change; (4) climate policy; and (5) the politics of climate change. The book is well-written, but I found that some parts might be a little too technical for the general reader. However, Nordhaus does an excellent job of citing the important literature, presenting the data, and developing a robust and believable argument, so the general reader will be able to get through it.

Nordhaus's favoured policy is clearly a carbon tax, although I get the feeling that he would be happy with any policy that results in pricing carbon and thereby leading to incentives to reduce carbon emissions. In ECON110, we look at both carbon taxes and emissions trading as potential solutions to the climate change externality, and the book gives some good discussion of those options, as well as command-and-control-type regulations.

Finally, having worked for a number of years with physical scientists on climate change projects (see this recent post on one climate change project), I think this book should be required reading for climate scientists. In particular, this bit:
Climate-change policy is a tale of two sciences. The natural sciences have done an admirable job of describing the geophysical aspects of climate change. The science behind global warming is well established...
But understanding the natural science of climate change is only the first step. Designing an effective strategy to control climate change will require the social sciences - the disciplines that study how nations can harness their economic and political systems to achieve their climate goals effectively. These questions are distinct from those addressed by the natural sciences.
To be fair though, the physical scientists that I have been working with are well aware of this point (which is why economists and other social scientists have been part of the research teams!). Climate change is a global problem, and is going to require global solutions. And those solutions involve people and politics, which is why the social sciences (not just economics, but political science, psychology, and other disciplines) need to be part of the conversation.