Signaling and Efficiency in Gift Exchange: An Application to Tipping

In the gift exchange principal–agent game, other-regarding preferences can be sufficient to support an efficient equilibrium with a strictly positive transfer. When the agent is uncertain about the altruism of the principal or the extent to which the principal adheres to social norms, however, he chooses a suboptimal level of effort to insure himself against unfair outcomes. I demonstrate that under certain conditions, a relatively simple change to the structure of the game allows the principal to costlessly signal his type and restores efficiency. I argue that this result has implications for the design of gratuity-based service industries.