Int. Rev. Econ.

(2007) 54:405427
DOI 10.1007/s12232-007-0024-3

Fertility, income and welfare in an OLG model

with regulated wages

Luciano Fanti Luca Gori

Received: 31 March 2007 / Accepted: 24 September 2007 / Published online: 31 October 2007
Springer-Verlag 2007

Abstract We analyse the effects of the regulation of wages in a standard one-

sector OLG model of neoclassical growth extended to account for endogenous
fertility decisions of households and unemployment benefit policies financed at
balanced budget. In contrast with the prevailing literature, which has failed to pay
due attention to inter-temporal contexts, our conclusion is that minimum wages may
be introduced not only for equity reasons, that is, to increase the income of low-paid
workers, but under suitable conditionsi.e., if production is sufficiently capital
oriented and the unemployment benefits are high enoughminimum wage legis-
lation might be considered as a source of increased economic performance despite
unemployment, i.e. a regulated-wage economy performs better than a market-wage
economy. As a consequence, since higher minimum wages raise per capita income
together with increasing unemployment, our results imply that a positive correlation
between unemployment and long-run income per-capita may exist. Further, the
lifetime welfare of the representative generation may be increased as well. Finally,
the wage rate may also be treated as a policy instrument for the control of popu-
lation growth.

Keywords Endogenous fertility
Regulated wage
OLG model

Welfare

JEL Classification E24
H24
J13
O41

L. Fanti
L. Gori (&)

Department of Economics, University of Pisa, Via Cosimo Ridolfi, 10, 56124 Pisa (PI), Italy
e-mail: luca.gori@ec.unipi.it
L. Fanti
e-mail: lfanti@ec.unipi.it

123
406 L. Fanti, L. Gori

1 Introduction

Although a vast debate about the macroeconomic consequences of minimum

wages1 has been developed dating from Stigler (1946), less attention has been paid
to the long-run effects of the regulation of wages in a dynamic context (i.e., a simple
OLG framework). The idea that the introduction of minimum wages in a simple
competitive one-sector2 economy always brings an output loss due to unemploy-
ment is a widespread belief.3 Furthermore, the prevailing literature (e.g., among
others, Bean and Pissarides 1993; Daveri and Tabellini 2000) establishes a negative
relationship between unemployment and growth: i.e., unemployment always
deteriorates growth.
Indeed only few papers have found possible positive long-run macroeconomic
effects of the minimum wage legislation in an inter-temporal OLG context, for
example Cahuc and Michel (1996) and Ravn and Sorensen (1999). However, in
these papers such a possibility depends on the specific assumption of a positive
relationship between the unemployment created by the minimum wage and the
long-run productivity growth induced by schooling and on-the-job training; such a
disputable assumption introduced a positive externality which implies a departure
from the conventional OLG model (Diamond 1965) we have adopted. In
particular, none of these models are concerned with the role played by government
interventions on the labour market, such as minimum wage legislation along with
unemployment insurance mechanisms, in a context of endogenous fertility. In this
paper we will try to fill the gap by developing a standard OLG model of
neoclassical growth embodying such features. The value added of this paper
grounds on three novel results, which have so far escaped closer scrutiny: (1)
under suitable conditionsthat is, sufficiently high weight for capital in
technology and sufficiently high unemployment benefitsa regulated wage
economy may perform better than a market-wage economy; (2) the correlation
between unemployment and income per-capita may be positive; and (3) the level
of the regulated wage may also be treated as a policy parameter for the control of
population growth.

1
It is worth noting that in this model where, for simplicity, only one type of labour does exist, a binding
minimum wage simply indicates a regulated wage fixed by law over the market-clearing level. In the case
of more than one type of labour with uniformly distributed wages, this assumption would simply mean a
regulated wage fixed over the average market wage.
2
Note that it is well known that when there is a market distortion, such as a monopsonistic labour
market, or if there are two sectors (e.g., manufacturing and agriculture), the literature has argued that the
introduction of a minimum wage may increase efficiency. For instance, a recent paper which, in a two-
sector economy, picks up the conditions for a binding minimum wage to be efficiency-improving in
presence of taxes is Gokcekus and Tower (2003). However, even in the cases of monopsonistic labour
market and/or two-sector economy, the literature has focused only on static contexts. On the contrary, the
case of dynamic endogenous determination of capital per-capita has not been so far investigated (for
instance, Grimes and Tower 1998, p 214, in a simulation analysis of the optimum minimum wage,
conjecture that the optimum minimum wage would be lower if the capital stock were endogenous).
3
For instance, it is generally recognized that minimum wage legislation induces distortions which have
adverse effects on the efficiency of the economy (Cahuc and Michel 1996, p 1464).

123
Fertility, income and welfare in an OLG model with regulated wages 407

The basic idea behind our results may be summarised as follows: a minimum
wage, will increase the income of the currently young generation on one side but on
the other side it will lead to unemployment as the hourly wage is fixed at too high a
level for the labour market to be cleared. In the short-run, this brings about either an
increase or a decrease in the overall income of the younger generation (depending
on the size of the unemployment insurance benefit) and thus in saving as well. As
regards fertility and time spent working, we note that, with both population growth
and labour supply being endogenous, the individual, in principle, is allowed to
choose to supply more labour and have less children or to supply less labour and to
raise more children. Nevertheless, the final result is that the introduction of
minimum wages, establishing a (short-run) negative correlation between unem-
ployment and fertility, entails a lower number of children. Moreover, fertility may
reduce more than savings. In the light of the latter effect (a lower fertility rate), the
pace of accumulation of capital per-capita (which depends on the ratio between
savings and the demand for children) in the regulated-wage economy may be higher
than the capital accumulation path in the competitive-wage economy. The possible
increase in capital accumulation is, however, only a first necessary engine of a
possible higher per-capita income.4 Another conditionwhich depends on
technologyis essential for the long-run income to be improved by the regulation
of wages, and the mechanism is the following: in contrast with the static context in
which a regulated wage always brings upon an output loss due to a labour demand
reduction, the other input (the capital stock) being fixed, in a dynamic context the
effect of minimum wages on income per-capita depends on two counterbalancing
forces: on the one hand the induced increase in the capital input and, on the other
hand, the induced reduction in the labour input. Whether transitional economic
growth and long-run per-capita output will be reduced or increased by the
introduction of a regulated wage will depend ultimately on the weight of the capital
input in the production function.
Therefore, if capital accumulation is improved by the regulation of wages and the
capitals weight in production is high enough, the transitional rate of growth as well
as the long-run income per-capita are higher in a regulated-wage economy than in
the standard competitive-wage economy. But the noteworthy improvement in the
long-run level of per-capita income is not the end of the story: the regulation of
wages may also generate an increase of individuals lifetime welfare due to the
increased lifetime consumption which overcompensates the reduced demand for
children, provided that individuals are not too much interested in smoothing
consumption over time and having children.5 Finally we note that, when per-capita
output is enhanced by the regulation of wages, a self-evident corollary is that the

4
As known, the neoclassical growth theory (e.g., Solow 1956; Mankiw et al. 1992) refers to the level
(rather than to the rate of growth) of the long-run income. In any case, needless to say, an increase in the
long-run level of output, implies a transitional increase in the rate of growth as well.
5
We note that whether the regulation of wages is both growth and welfare enhancing or not depends
ultimately only on tastes, technology and the level of the replacement ratio.

123
408 L. Fanti, L. Gori

correlation between unemployment and long-run economic performance, in contrast

with the prevailing literature, is found to be positive.6
It must be emphasised that we have sought to clarify these theoretical findings
using as parsimonious a model as possible, that is, the standard Diamonds (1965)
OLG model of growth here extended to account for endogenous fertility decisions
of households, minimum wage legislation and unemployment benefit policies.
The paper is organised as follows. In Sect. 2 we present the competitve-wage
economy. In Sect. 3 we introduce minimum wages, and the main results of the
model are analysed and discussed by comparing both competitive-wage and
regulated-wage economies. Finally, Sect. 4 bears the conclusions.

2 The market-wage economy

In this section we briefly present the basic Diamond (1965) OLG model7 extended
to account for endogenous fertility decisions of households, and we will refer to it
throughout the paper as the competitive or market-wage economy.

2.1 Individuals

Agents have identical preferences and are assumed to belong to an overlapping

generation structure with finite lifetimes. Life is separated among three periods:
childhood, young adulthood and old-age. During childhood individuals do not make
decisions. Adult individuals belonging to generation t have a homothetic and
separable utility function defined over consumption when young (cyt ) and old (cot+1)
and from having children (nt),8 as in Galor and Weil (1996). Each agent is supposed
to have an endowment of one unit of time. We assume that raising children requires
a time cost 0 \ q \ 1 per child, that is, q represents the (exogenous) fraction of the
time endowment of one parent that must be spent in order to raise one child.9 This
hypothesis results in an endogenous supply of labour: there exists, in fact, a trade-
off between working in the labour market and raising children, that is, the time

6
The positive effect of unemployment on both income per-capita and welfare, as shown in this paper,
does not exclusively depend either on the type of taxation used or on the hypothesis of endogenous
fertility. For instance it may hold even with exogenous fertility and with different tax policies (e.g.,
consumption taxes, capital income taxes, and so on), evidencing that the results of this paper are a robust
feature of regulated wage economies (see Fanti and Gori 2007).
7
Two reference textbooks are Azariadis (1993) and De La Croix and Michel (2002).
8
Note that nt represents the number of children with nt @ 1 being the population growth rate (for
simplicity, the mortality rate has not been included in the analysis). Some authors, including Samuelson
(1975), used Nt+1/Nt = 1 + n with n representing the population growth rate. Our approach is used in most
papers with endogenous fertility.
9
We assumed a time cost to rear children to capture the idea that a link between time spent raising
children and time spent working does exist, that is, the labour supply is affected by the time cost of child-
rearing (e.g., Galor and Weil 1996). Moreover, for a better understanding of such an assumption, the time
cost to raise children may be conveniently interpreted as an opportunity cost of the parents home time
which is increasing in their working income (see Cigno 1991).

123
Fertility, income and welfare in an OLG model with regulated wages 409

devoted to rear children cannot be spent working, so that the opportunity cost to
give birth and raise each child is proportional to the wage received by each young-
adult individual.
Only young-adult individuals (Nt) join the labour force devoting a fraction
ht(nt) = 1 @ qnt of their time to work in the market with qnt being the share of time
spent raising children. As an adult, each young-aged individual earns the
competitive wage at the rate wt. This income is used to consume and to save.
During old-age agents are retired and live on the proceeds of their savings (st) plus
the accrued interest at the rate rt+1, where rt+1 is the rate of return on savings from
period t to period t + 1. Each adult individual is assumed to be a price-taker.
The representative individual born at time t is faced with the problem of
maximising the following logarithmic utility function:10




maxfcy ;co ;nt g Ut cyt ; cot1 ; nt 1  / ln cyt / ln cot1 q ln nt ;
t t1

subject to the intra-temporal budget constraints

cyt st wt ht nt ;
cot1 1 rt1 st

where 0 \ / \ 1 represents the relative weight between consuming during young

adulthood and old-age, with //(1 @ /) being the subjective discount rate, and
q [ 0 captures the weight of the parents taste for children in the welfare evaluation.
The higher / the more individuals smooth consumption over time, and the higher q
the more parents are children-interested.
The first-order conditions for an interior solution are given by
cot1 /
1 rt1 ; 1
cyt 1/
q 1/
y
qwt : 2
nt ct
Equation (1) equates the marginal utility of current and future consumption in terms
of current consumption, whereas Eq. (2) equates the marginal utility of having a
child with the involved marginal costs in terms of forgone utility of consumption.
Exploiting Eqs. (1) and (2) along with the individuals budget constraints, the
demand for children and both young-adult and old-age consumption are determined
by
q
nt : nc ; 3
1 qq

10
Since there exists a trade-off between working in the labour market and raising children, the Cobb-
Douglas utility function we have adopted captures the individuals utility drawn from having children,
working period consumption and retirement period consumption; that is, once the number of children
(and, thus, the share of time spent to raise children) has been chosen optimally by individuals, the hours
devoted to the labour market are determined as well. Overall, our model endogenously determines
consumption of both periods of adulthood, savings, the fertility rate and the time spent working.

123
410 L. Fanti, L. Gori

1/
cyt wt ; 4
1q
/
cot1 1 rt1 wt ; 5
1q
Note that Eq. (3) implies that the number of children chosen optimally by
individuals is constant over time, that is, n does not depend on wages, and, as
expected, an increase in the fraction of the time endowment spent as a cost of
raising a child (a higher value of q) and a reduction in the preference for children in
the welfare evaluation (a lower value of q) reduce the fertility rate.
The optimal savings path, instead, is expressed as
/
st wt : 6
1q

2.2 Firms

All the firms on the economy are identical and own a constant returns to scale Cobb-
Douglas technology of production by which capital (Kt) and labour (Lt = ht(nt)
Nt)
are transformed into final goods and services (Yt). Thus, the representative profit-
maximising firm hires aggregate capital stock as well as labour supplied by young
agents to determine aggregate production, that is, Yt = AKat L1@a t , where A [ 0
represents a scale parameter and a [ (0,1) is the capital weight in technology.
Defining kt := Kt/Nt and yt := Yt/Nt as capital and output per-capita respectively, the
intensive form production function is
yt Akta ht nt 1a : 7
Factor prices are taken as given. Thus, normalising the price of output to unity,
profit maximisation leads to the following marginal conditions for capital and
labour:11
 
kt a1
rt aA  1; 8
ht nt
 
kt a
wt 1  aA : 9
ht nt

2.3 Equilibrium

The model is closed with the analysis of the long-run equilibrium. The equilibrium
of the output good market is yt = cyt + cot /nt@1 + ntkt+1, which, by substituting the

11
We suppose that capital totally depreciates over time, i.e. d = 1. This assumption is not unrealistic in
the present context, because as noticed by De La Croix and Michel (2002, p 338) even if one assumes a
rather low annual depreciation rate of 5, 79% of the stock of capital is depreciated after 30 years.

123
Fertility, income and welfare in an OLG model with regulated wages 411

kt+1

kt+1=f(kt)

k*c kt

Fig. 1 The capital accumulation path in the competitive-wage economy, kt+1 = f(kt). Parameter set:
A = 20, a = 0.60, / = 0.10, q = 0.20 and q = 0.10

zero profit condition and the households budget constraints, implies that the
market-clearing condition in goods as well as in capital market is expressed by the
equality between savings and investments, i.e., with the hypothesis of full
depreciation of capital at the end of each period, and knowing also that Nt+1 = ntNt
equilibrium implies ntkt+1 = st, i.e. the stock of capital in period t + 1 equals the
amount saved in period t discounted by the number of individuals. Substituting for s
and n according to Eqs. (6) and (3), respectively, and using Eq. (9), the evolution of
capital is driven by the following first-order non-linear difference equation:
/q
kt1 1  aA1 qa kta : 10
q
Steady-state implies kt+1 = kt := k*. Therefore, the long-run (per-capita) stock of
capital is simply:12
 1a
1
/q a
kc 1  aA 1 q1a : 11
q
The following figure shows the behaviour of the capital accumulation path in the
market-wage economy together with the steady-state per-capita stock of
capital(Fig. 1).13

12

okt1 
As regards stability, we find that 
okt kt kc a\1; i.e. the steady-state equilibrium is always stable.
13
The parametric set used for all the figures shown in the Sects. 2 and 3 is based on plausible values of
parameters, but it has been chosen only for illustrative purposes (see, for instance, the discussion of the
value of a at the end of Sect. 3.3).

123
412 L. Fanti, L. Gori

Using kc* and nc*, the long-run per-capita output level is given by

a 
 1a
yc A kc hc nc : 12
Further, the long-run interest rate and the market-clearing wage are respectively
given by
" #a1
 kc
rc aA 
   1; 13
hc nc
" #a  a
 kc /q1 q 1a 1
wc 1  aA 
  1  aA1a : 14
hc nc q

3 The regulated-wage economy

We now extend the basic dynamic general equilibrium (one-sector) OLG model
typified in the previous section to account for minimum wage legislation as well as
unemployment benefit policies financed at balanced budget with lump-sum taxes
levied on the younger generation. The economy is closed to international trade, and
goods and capital markets are both competitive. The model is outlined as follows.14

3.1 Individuals

As an adult each agent earns a constant binding minimum wage w fixed by law over
the prevailing market-clearing level: thus, the labour market does not clear and
involuntary unemployment occurs. In order to tackle the unemployment issue, we
assume the existence of an unemployment insurance scheme which pays propor-
tional-to-wage benefits for the unemployed time, i.e. bw : c w; with 0 \ c \ 1
being the so-called replacement ratio, represents the benefit perceived by each
young-adult individual for each unemployed hour.15 The aggregate unemployment
rate (defined in terms of hours not worked) is ut = [ht(nt)Nt @ Lt]/ht(nt)Nt, where Lt is
the labour demand. Thus, the representative individuals total income is defined to be
the sum of the working income, w1  ut ; plus the unemployment benefit, cw ut :16
This income is used to consume, to save and to pay taxes. Therefore, in the regulated-
14
Since one scope of this paper is to isolate the relation between individuals fertility and minimum
wages, as a first attempt we ignore both the trade-off between child quantity and quality and the
assumption that parents maximise the utility of their offspring, which have been employed to explain
economic growth and stagnation byamong othersBecker et al. (1990) and Ehrlich and Lui (1991).
15
This is the typical case of the Italian unemployment insurance system (i.e., Cassa Integrazione
Guadagni) which pays benefits for the unemployed hours due to temporary and partial layoffs.
16
Note that in this model there is no uncertainty, and each young-adult agent will be employed for
1 @ ut hours and unemployed for ut hours. In other words, we are assuming that the minimum wage
reduces the number of hours employed by each household, rather than causing some households to be
employed at the higher wage and other households to be unemployed. We note that if we had adopted the
other assumption, the saving behaviour would be unchanged while fertility behaviour would be different
(owing to the fact that the unemployed households would not incur in time-child-rearing cost). However,

123
Fertility, income and welfare in an OLG model with regulated wages 413

wage economy, the opportunity cost to give birth and raise children is proportional to
the total income received by each young adult individual, that is, increasing both the
minimum wage and the replacement ratio affects the time-input required to raise
children. This is due to the fact that unemployment benefits are paid on the basis of
the fraction of the hours chosen by individuals to be spent on the labour market which
instead remain unemployed as the hourly wage is fixed at too high a level for the
labour market to be cleared.
During old-age agents are retired and live on the proceeds of their savings (st)
plus the accrued interest at the rate rt+1. The representative individual born at time t
is faced with the problem of maximising the following logarithmic utility function:




maxfcy ;co ;nt g Ut cyt ; cot1 ; nt 1  / ln cyt / ln cot1 q ln nt ;
t t1

subject to intra-temporal budget constraints:17

cyt st w1  ut cw ut 
ht nt  st
cot1 1 rt1 st

where st [ 0 is a lump-sum tax levied on the young-adult generation.

The first-order conditions for an interior solution are
cot1 /
1 rt1 ; 15
cyt 1/
q 1/
y
qw1  ut cw ut : 16
nt ct
Equations (15) and (16) have the same economic interpretation than Eqs. (1) and
(2). However, now, Eq. (16) shows that the higher both the minimum wage and the
replacement ratio, the higher the opportunity cost of having children.
Using Eqs. (15) and (16) along with the households intra-temporal budget
constraints, the demand for children and consumption of young adulthood and old-
age are given by
q w1  ut cw ut  st
nt
; 17
1 q qw1  ut cw ut 
1/
cyt w1  ut cw ut  st ; 18
1q

Footnote 16 continued
the qualitative results of this paper would hold adopting the other assumption as well. A more detailed
analysis of the other assumption is left for future research.
17
Notice that in our model we are not taking into account for the important leisure values associated with
unemployment: for instance leisure time, self-enrichment activities, education, home production and so
on. Indeed unemployment is to be interpreted as work-free hours of life. The use of unemployed hours
either for self-enrichment activities or for exploiting home production technologies are interesting
extensions which are beyond the scope of the present paper.

123
414 L. Fanti, L. Gori

/
cot1 1 rt1 w1  ut cw ut  st ; 19
1q
while the optimal saving path is given by
/
st w1  ut cw ut  st : 20
1q

3.2 Government

A straightforward effect of the regulation of wages is to cause a positive level of

unemployment. Further, the presence of an unemployment insurance mechanism
raises the need to finance the payment of benefits. We suppose the government
levies and adjusts over time lump-sum taxes on the younger generation such as to
balance out unemployment benefit expenditures with tax receipts in every period.
Thus, the per-capita time-t government constraint is
cw ut ht nt st : 21
We have deliberately chosen a purely redistributive tax policy in which only the
younger generation is involved, that is, income taxed away from the young returned
to the same individuals as a benefit for the hours of unemployment. This distinctive
feature is important because in OLG models, as known dating back to Atkinson and
Sandmo (1980), Sinn (1987), Bertola (1996) and Uhlig and Yanagawa (1996),
taxing capital income (or, alternatively, introducing any other form of transfer from
old-aged to young-aged individuals) could lead to faster economic growth.
Therefore, since in our model the tax policy does not cause any transfer from
dissavers to savers, that is, from the old-age to the younger generation (as, instead, it
would have been the case with capital income taxes), the effects on demographic
and macroeconomic variables as well as on the lifetime welfare of the representative
generationas described in this papershould be entirely ascribed to the working
of both minimum wages and unemployment benefits rather than to the intergen-
erational tax transfer channel.

3.3 Firms

There are two factors of production: capital (K) and labour (L). The representative
firm owns a constant returns to scale Cobb-Douglas technology by which capital
and labour are transformed into final goods and services, that is, Yt = AKat L1@a
t ,18
where A [ 0 represents a scale parameter and a [ (0,1) is the capitals weight in
technology. It hires aggregate capital stock as well as labour (Lt = (1 @ ut)

ht(nt)
Nt)according to their marginal productivityto maximise profits. Defining

18
Adding exogenous growth in labour productivity does not alter any of the substantive conclusions of
the model and, hence, it is not included here.

123
Fertility, income and welfare in an OLG model with regulated wages 415

kt := Kt/Nt and yt := Yt/Nt as capital and output per-capita, respectively, the

intensive form production function becomes

yt Akta 1  ut ht nt 1a : 22
Assuming that final output is traded at unit price, profits maximisation leads to
the following marginal conditions for capital and labour, respectively:
 a1
kt
rt aA  1; 23
1  ut ht nt

 a
kt
w 1  aA : 24
1  ut ht nt
As far as labour is concerned, the marginal product of labour will adjust to meet the
fixed real wage with ut being endogenously determined. Thus, knowing that the
representative firm has the right to hire as many workers as dictated by the per-
ceived labour demand curve, exploiting Eq. (24) the short-run rate of
unemployment is given by
 1a
1  aA kt
ut kt ; w; nt 1 
; 25
w ht nt
which is positively related to both the minimum wage and the number of hours spent
working in the labour market, and strictly decreasing in the per-capita stock of
capital.
Once the wage has been fixed, the real rate of interest is exogenous (that is,
capital returns are independent of the capital stock). A binding minimum wage, in
fact, necessarily causes any increase of the capital stock to be matched by an
identical increase in the employment level, keeping the capitallabour ratio constant
over time. Indeed, substitution of Eq. (25) into Eq. (23) yields:
 1a
1  aA a
r w aA  1; 26
w
so that increasing the minimum wage always pushes down the real interest rate
below its competitive level.
In order to better clarify the meaning of the coefficient a (the capitals weight
in technology), it is worth noting that a possible interpretation is that the capital
stock may be thought in its broad concept, including physical and human
components and that the labour input only includes non-specialised labour. In
fact, as argued by Mankiw et al. (1992, p 417), the minimum wage may be
considered to be a proxy of the return to labour without human capital; they
suggest that since the minimum wage has averaged about 3050% of the average
wage in manufacturing, then 5070% of total labour income represents the return
to human capital, so that if the physical capitals share of income is expected to
be about 1/3, the human capitals share of income should be between 1/3 and

123
416 L. Fanti, L. Gori

one half. In sum, with the broad view of capital the coefficient a may be fairly
about 0.6 and 0.8.

3.4 The demand for children and the saving path

Inserting Eq. (21) into Eq. (17) to eliminate st, using Eq. (25) and rearranging terms
gives the following non-linear equation of nt:
q1  ut kt ; w; nt 
nt : 27
qf1 q
1  ut kt ; w; nt  c ut kt ; w; nt g
After some cumbersome algebra, the two solutions of Eq. (27)as a function of the
per-capita stock of capital and the minimum wagemay be expressed as
 q
1
nt;1 kt ; w c 1  c qpkt  c 1  c qpkt 2  4cqpkt ; 28
2qc
 q
1
nt;2 kt ; w c 1  c qpkt c 1  c qpkt 2  4cqpkt ; 29
2qc
 1
1  aA a
where p : :
w
However, the demand for children is exclusively determined according to Eq. (28)
with Eq. (29) being economically irrelevant, since it implies an unemployment rate
greater than unity. Therefore, in what follows we neglect Eq. (29), so that the short-run
fertility rate chosen by individuals is given by Eq. (28).
From Eq. (28) it can be shown that minimum wage legislation induces distortions
which negatively affect fertility decisions of households (that is, Modern Fertility
Effect).19 Note that in the case of competitive labour market, the population growth
rate is constant over time [see Eq. (3), Sect. 2]. Therefore, such a Modern response
of the fertility rate may be addressed to be a peculiar characteristic of minimum
wage legislation which introduces a correlation among fertility-unemployment-
wages (see Eq. 27).
Exploiting Eqs. (20), (21) and (25), and knowing also that the hours spent
working are affected by the time devoted to child-rearing activities, i.e. ht(nt) =
1 @ qnt, the optimal savings path may be expressed as
/
st
fw1  ut kt ; w; nt  cwut kt ; w; nt
qnt g; 30
1q

19
The impact of raising minimum wages on the short-run fertility rate is analytically complicated and
= 
z}|{ z}|{
dnt;1 ont;1 op ont;1 [
non-monotonic:
; where 0 if and only if 2c 1  c qpkt 
dw op ow op \
1  c qkt  4cqkt \[ 0: Exhaustive numerical experiments indicate that the introduction of minimum
dnt;1
wages always depresses the short-run fertility rate, that is, \0:
dw

123
Fertility, income and welfare in an OLG model with regulated wages 417

The endogenous determination of optimal saving (30) may be split among two parts:
a constant propensity to save20 (the term //(1 + q)) and the total income of the
currently young generation (the term in graph brackets), which depends on the time-
t per-capita stock of capital, the hours devoted to child-rearing activities, the
unemployment rate and the (constant) minimum wage. The first addendum in graph
brackets represents the working income of young aged individuals while the second
one is the total unemployment benefit perceived by the same individuals. Note that
owing to the working of the balanced budget lump-sum tax, we found the somewhat
paradoxical result that increasing the share of time spent to raising children (q
n),
and thus reducing the time spent working, raises the total income of the currently
young generation in a way proportional to the unemployment benefit.
Substituting the right-hand side of Eq. (27) into Eq. (30) for n and rearranging
terms we find that
/w1  ut kt ; w; nt 
1  ut kt ; w; nt
1  c
st : 31
1 q
1  ut kt ; w; nt  cut kt ; w; nt

3.5 Equilibrium

We now combine all the pieces of the model to characterise the long-run
equilibrium. Given the equilibrium of the output good market yt = cyt + cot /
nt@1 + ntkt+1, the zero profit condition, the household and government budget
constraints, the market-clearing condition in goods as well as in capital markets may
be expressed by the equality between savings and investments, i.e. with the
hypothesis of full depreciation of capital at the end of each period, and knowing also
that Nt+1 = ntNt equilibrium implies ntkt+1 = st, meaning that the stock of capital
per-capita in period t + 1 equals the amount saved in period t discounted by the
number of individuals. Substituting for nt and st according to Eqs. (27) and (31)
respectively, yields:
st /q
kt1 w1  ut kt ; w; nt
1  c: 32
nt q
Upon

substitution  of Eq. (28) into Eq. (25) for nt;1 kt ; w and using
ut kt ; w; nt;1 kt ; w ; the evolution of capital is driven by the following first-order
non-linear difference equation:21

20
As known, the optimal saving function of households derived by any homothetic utility function has
the property to be made up of a propensity to save multiplied by the income of young aged individuals
(see, for instance, De La Croix and Michel 2002, p 54, Proposition 1.12, showing that when preferences
are homothetic, the saving function is linear with respect to wage, and the propensity to consume does not
depend on wage). In particular, with logarithmic preferences (see Diamond 1965, p 1134) the propensity
to save is a constant.
21
Note that the law of motion of capital results in a non-linear relationship among capital per-capita in
subsequent periods. However, as shown in Fig. 2 below, such a relation tends to be quasi linear whatever
the value of the basic parameters of the model and the minimum wage.

123
418 L. Fanti, L. Gori

/2qcwpkt
kt1 q : 33
c 1  c qpkt  c 1  c qpkt 2  4cqpkt

Steady-state implies kt+1 = kt = k*. Despite the non-linearity of Eq. (33), after some
cumbersome manipulations, the unique positive solution for the long-run per-capita
stock of capital as a function of the minimum wage is given by
h 1a 1
i
/qcw w a  /q1  aAa
k  w 1a 1 : 34
qw a  /q1  c q1  aAa
a 1
The numerator of Eq. (34) is positive for any w [ wN : /q1a 1  aA1a ;
h ia 1
whereas the denominator is positive for any w [ wD : /q1cq
q
1a
1  aA1a
with wN \ wD. Therefore, a necessary and sufficient condition for the existence of
k w [ 0 is w [ wD : Since wD \wc \w holds true, Eq. (34) is defined whatever
the minimum wage fixed by the policymaker. We will show that in steady-state the
per-capita stock of capital as well as the output per-capita may be a positive function
of the minimum wage, and in particular both can be higher than the corresponding
values in the competitive-wage economy despite the employment reduction created
by the regulation of wages.
Differentiation of Eq. (34) with respect to w yields:
ok w aqw2 a  /q1  c 2aq1  aAa w a /2 q2 a1  c q1  aAa
1a 1 1a 2

h i
1 2
:
ow 1a 1a
aw a qw a  /q1  c q1  aAa
35
ok w
Furthermore, 0 if and only if the following (positive) roots hold:
ow
" #1a
a

2aq
w w1 : p
wD ; 36
1  c 2aq 1  c1  c 4aq1  a
" #1a
a

2aq
w w2 : p
wD ; 37
1  c 2aq  1  c1  c 4aq1  a

with w2 [ w1. It is easy to verify that w1 \ wD and w2 [ wD, so that w w1 is not

economically relevant. It is worth to note that, depending on the mutual relation
between technology, policy and preference parameters, a, c and q, respectively,
w w2 may be higher or lower than the steady-state market-clearing wage, wc*.
Therefore, the following proposition holds:
Proposition 1 Let a, c and q be such that w2 \ wc*. Then, k w [ kc for any
w [ wc :
ok w ok w
Proof Since ow \0 for any w\w2 and ow [ 0 for any w [ w2 ; and
knowing also that k w kc if and only if w wc ; then w w2 is an inner
absolute lower bound of k w for any w [ wD ; and the condition w2 \ wc* implies
k w [ kc for any w [ wc : h

123
Fertility, income and welfare in an OLG model with regulated wages 419

kt+1

kt+1=f(kt,w)

kt+1=f(kt,w)

kt+1=f(kt)

k*c k* (w) k*(w) kt

Fig. 2 The capital accumulation path in both the competitive-wage, kt+1 = f(kt), and regulated-wage,
kt1 f kt ; w; economies. The market-clearing wage is wc* = 2.66 and the two minimum wage values
(chosen for illustrative purposes) are w0 3 and w00 3:5 respectively. The steady-states are given
by kc  0:133; k w0 0:148 and k w00 0:171: As regards stability, we find that
 
okt1 =okt kt k w0 0:105 and okt1 =okt kt k w00 0:092; that is, the steady-state equilibrium in the
minimum-wage economy is globally stable. Parameter set: A = 20, a = 0.60, / = 0.10, c = 0.90,
q = 0.20 and q = 0.10

Proposition 1 says that the long-run accumulation of capital in the regulated-

wage economy may be always higher than the one in the market-wage economy.
This result is favoured the higher both the capitals weight in technology and the
replacement ratio, and the lower the taste for children in the welfare evaluation.
Figure 2 below compares the dynamics of capital in the competitive-wage
economy with the one in the regulated-wage economy. The positively sloped
straight line in the figure represents the locus of accumulation of capital in the
minimum-wage economy, Eq. (33), while the concave curve describes the dynamics
of capital in the market-wage economy, Eq. (10). It is shown that if both the
capitals weight in technology, a, and the replacement ratio, c, are high enough, the
capital accumulation path in the regulated-wage economy lies always above the
capital accumulation path in the competitive-wage economy for any k; as a
consequence, k w [ kc for any w [ wc ; as clearly shown in the figure. Moreover,
increasing the minimum wage shifts upward the straight linewith its slope being
unchangedand thus both the transitional rate of growth of the economy and the
steady-state per-capita stock of capital are increased as well. Figure 3 depicts the
transitional rate of growth by comparing market-wage
  and minimum-wage
economies. The growth rate of the economy g kt1kk
t
t
is defined to be the
difference between the horizontal straight line and the convex curve. By looking at

123
420 L. Fanti, L. Gori

kt+1/ kt
g(w) g (w)

gc

k*c k* (w) k*(w) kt

Fig. 3 The transitional growth rate in both competitive-wage, gc, and regulated-wage, gw; economies.
The growth rate in the competitive-wage economy is the difference between the straight line and gc, while
the growth rate in the minimum-wage economy is the difference between the straight line and gw: It is
easy to see that gw [ gc for any k \ kc*. Parameter set: A = 20, a = 0.60, / = 0.10, c = 0.90, q = 0.20
and q = 0.10

the figure, it is easy to see that the minimum-wage economy performs better than the
market-wage economy whatever the initial level of capital. Moreover, if the
policymaker decides to increase the minimum wagefor reasons which may be
assumed to be exogenousthe curve gw shifts upward and to the right so that the
economy approaches to the new steady-state at higher rates.
Substituting Eq. (34) into Eq. (28) for k, we obtain the steady-state fertility rate
as function of the minimum wage:
 q
1
n1 w c 1cqpk w c 1cqpk w2 4cqpk w :
2qc
38
It is important to note that upon substitution of k w it can be shown that n1 w
does depend on the replacement ratio (c) but such a dependence is (numerically)
negligible, that is, on1 w=oc approaches zero whatever the value of the key
parameters of the model and the minimum wage.22 This implies that once the
minimum wage has been fixed by the policymaker, the fertility rate is fixed as well,

22
We do not present here a formal treatment of on1 w=oc since it is cumbersome and not economically
informative.

123
Fertility, income and welfare in an OLG model with regulated wages 421

n*(.)

n*c

n*1 (w)

w*c w

Fig. 4 The long-run fertility rate in both market-wage, nc*, and regulated-wage, n1 w; economies. The
starting point of the horizontal axis is the steady-state market-clearing wage, that is, wc* = 2.66. Note that
on1 w=oc 0; that is, the shape of the n1 w schedule is invariant for 0 \ c \ 1. Parameter set: A = 20,
a = 0.60, / = 0.10, q = 0.20 and q = 0.10

or alternatively, an increased unemployment benefit due to a higher replacement

ratio does not alter the long-run fertility rate freely chosen by individuals.
We now study the long-run response of the fertility rate to changes in the
minimum wage rate. The total derivative of (38) with respect to w gives:23
 = =
z}|{ z}|{ z}|{
dn1on on ok
1 1
:
dw ow ok ow
Although the latter derivative is not tractable in a neat analytical form, exhaustive
numerical simulations allows us to conclude that raising the minimum wage does
dn
always reduce the long-run fertility rate, that is, dw1 \0: As an example, consider the
following Fig. 4. It exhibits the negative response of the long-run fertility rate to
increases in the regulated wage (notice that when the minimum wage is fixed at too
high a level, population may even decrease). It must also be emphasised that the
behaviour of n1 w; as the one depicted in Fig. 4, remains unchanged as c varies,
that is, on1 w=oc 0: This means that the reduced demand for children may be
addressed to be a peculiar feature of minimum wage legislation which creates a

23 on [
Note that 1 0 if and only if 2c 1  c qpk w1  c qp  4cqp \
[ 0: Further, the sign
ok ok \
of is analysed in Proposition 1.
ow

123
422 L. Fanti, L. Gori

k*(.), s*(.),n*(.)
n*c

n*1 (w)

k*(w)

k *c

s*c
s*(w)

w*c w

Fig. 5 Saving, fertility and capital stock in the long-run. Parameter set: A = 20, a = 0.60, / = 0.10,
c = 0.50, q = 0.20 and q = 0.10

(negative) relation among fertility and unemployment as described by Eq. (27), with
n1 w being independent of unemployment benefit policies. Since the unemploy-
ment rate depends (positively) on the minimum wage, the fertility rate is found to be
a negative monotonic function of the wage.
It is worth to note that the long-run response of the saving function to the
introduction of minimum wages may be positive or negative, depending, for
instance, on the size of the replacement ratio (c). However, as we said in Sect. 1, the
long-run per-capita accumulation rate may increase despite the reduction of savings,
owing to a stronger reduction of the fertility rate. Figures 5 and 6 below depict two
cases of increasing k w with a decreasing (when c is low) and an increasing (when
c is high) saving function (s w in the figures), respectively. Note also that such
figures show that the long-run fertility decisions of households does not change as c
is increased.
Using Eqs. (34) and (38), the long-run unemployment rate is given by:24
 1
 1  aA a k w
u w 1 
: 39
w 1  q
n1 w
Therefore, the steady-state per-capita income is the following:
 1a
y w Ak wa
1  u w1a
1  q
n1 w : 40

24
Notice that the condition 0\u w\1 holds for any w [ wc : In fact, it can be shown that u w 0 if
and only if the steady-state market-clearing wage prevails, i.e. w wc and limw!1 u w 1:

123
Fertility, income and welfare in an OLG model with regulated wages 423

k*(.), s*(.),n*(.)
nc*

n*1 (w)

k*(w)

kc*
s* (w)
sc*

wc* w

Fig. 6 Saving, fertility and capital stock in the long-run. Parameter set: A = 20, a = 0.60, / = 0.10,
c = 0.90, q = 0.20 and q = 0.10

Note that when the steady-state market-clearing wage prevails, i.e. w wc ; and thus
the unemployment rate is zero, the standard results of the competitive-wage
economy in terms of capital per-capita, fertility rate and output per-capita hold, that
is k w kc ; n1 w nc and y w yc :
Since Eqs. (38)(40) are difficult to handle analytically, we present a qualitative
analysis (for a parametric configuration chosen only for illustrative purposes), which
may help us to evaluate how capital stock per-capita, income per-capita and fertility
rate change along with the level of the regulated wage, to show that the minimum-
wage economy may perform better than the market-wage economy despite the
unemployment occurrence, and that the regulation of wages introduces a positive
correlation between unemployment and long-run per-capita output as well as a
negative correlation between fertility and wages. The latter feature implies that the
minimum wage may be used by the policymaker as a parameter to control
population growth.
Figure 7 depicts the behaviour of the long-run per-capita stock of capital,
Eq. (34), as well as the long-run per-capita income, Eq. (40), comparing both
minimum-wage and market-wage economies. The figure clearly shows that there
exists a positive relationship between minimum wages and output per-capita (and
thus between unemployment and output) indicating that the policymaker should fix
as high a regulated wage as possible to increase the long-run output level. As a
consequence, the higher the minimum wage the higher both output and
unemployment.

123
424 L. Fanti, L. Gori

k *(.), y *(.)

y *(w)

yc*

k *(w)

kc*

wc* w

Fig. 7 The long-run stock of capital and the long-run income in both market-wage and regulated-wage
economies. y w is scaled 1:15. The starting point of the horizontal axis is the steady-state market-
clearing wage, that is, wc* = 2.66. Parameter set: A = 20, a = 0.60, / = 0.10, c = 0.90, q = 0.20 and
q = 0.10

Overall Figs. 4, 5, 6 and 7 show that the policymaker may choose a value of the
regulated wage aiming to reach as high an output level as possible compatible with
the desired population growth rate at balanced budget.
To sum up, if both the capitals weight in production and the replacement ratio
are high enough, and the preference for children in the welfare evaluation is low
enough, increasing the minimum wage brings upon an increase in the income of the
currently young generation with an increasing unemployment rate. This in turn
increases savings and reduces the long-run fertility rate, generating a higher pace of
accumulation of capital relative to the one obtained in the competitive-wage
economy. But this is not the end of the story: if capital is important enough in
production, the increased capital accumulation overcompensates the labour demand
reduction25 so that the long-run level of output per-capita is increased as well.
Therefore, minimum wages may be introduced not only for equity reasons, that is,
to raise the income of low-paid workers but, in the case in which production is
sufficiently capital-using, our dynamic general equilibrium neoclassical OLG model
states that minimum wage legislation, in contrast with the prevailing common

25
Note that with the hypotheses of both constant minimum wages and neoclassical labour market, firms
have the right to hire as many workers as dictated by their perceived labour demand curves. Thus, the
higher the minimum wage the higher the labour demand reduction needed to equate the marginal product
of labour to the fixed minimum wage.

123
Fertility, income and welfare in an OLG model with regulated wages 425

wisdom, may be considered as a source of increased income per-capita despite the

unemployment occurrence.

3.6 Welfare

After having discussed income and fertility outcomes of the model we turn to the
welfare analysis, which has been carried out in terms of comparing steady state
paths of the lifetime welfare of the representative generation, following, among
many others, Samuelson (1975).26
The government is supposed to be a Stackelberg leader with respect to
individuals and firms (Stackelberg followers). Given the followers behaviour and
knowing also that the lump-sum tax is an endogenous variable, the government
chooses the minimum wage such as to maximise the steady-state indirect utility
index of the representative generation, i.e.


maxfwg V  w 1  / ln cy w / ln co w q ln n1 w ; 41

subject to Eq. (38) and

1/  
cy w
w1  u w cwu wqn1 w ;
1q
/  
co w
1 r w
w1  u w cwu wqn1 w :
1q
Differentiating Eq. (41) with respect to w yields:
oV  w 1  / ocy w / oco w q on w
y
o

1 : 42
ow c w ow c w ow n1 w ow
Since Eq. (42) is not tractable in a neat analytical form, we turn to numerical
simulations to show that, given the unemployment benefit policy, if production is
sufficiently capital oriented (a:), the income of the younger generation is increased
by the regulation of wages even if the labour demand is reduced. Thus, both the
steady-state working period consumption of the adults and the steady-state
retirement period consumption of the adults are positive monotonic functions of
the regulated wage, that is, the increased income of the young overcompensates the
reduced interest rate, so that even the old-aged consumption may be enhanced by
minimum wages. Consequently, the representative generations lifetime welfare is
found to be a positive monotonic function of the regulated wage even if fertility
rates are reduced, i.e. the regulated-wage economy is welfare-preferred to the
market-wage economy whatever the minimum wage, as shown in the following
Fig. 8 plotted for the same parameter values of the previous figures.
As a result, welfare is positively linked to the unemployment rate.
Of course, we note that in the short run the welfare effect of the introduction of
minimum wages cannot be Pareto efficient (unless redistributive policies between

26
It is worth noting that in this paper we perform a positive rather than a normative analysis.

123
426 L. Fanti, L. Gori

V *(.)

V *(w)

V *(.)

wc* w

Fig. 8 The long-run lifetime welfare in both market-wage, Vc*, and regulated-wage, V  w; economies.
The starting point of the horizontal axis is the steady-state market-clearing wage, that is, wc* = 2.66.
Parameter set: A = 20, a = 0.60, / = 0.10, c = 0.90, q = 0.20 and q = 0.10

the two generations living at the moment of the introduction of minimum wage
legislation are implemented): indeed (1) the younger generation may be better off
(provided that the capital accumulation effect is sufficiently positive); (2) even if the
welfare of the younger generation is increased, the old generation always incurs in a
welfare loss due to the decreased interest rate. Anyway, the short run welfare
analysis is beyond the scope of the present paper.

4 Conclusions

In this paper we have focused on the steady state effects of the regulation of wages
on long-run per-capita income, welfare and fertility in a textbook one-sector OLG
model of neoclassical growth.
Our results differ markedly from conventional wisdom which argues that
minimum wages always bring upon a reduction in the level of income per-capita.
The reason for this wisdom is that it implicitly assumes a static context where
production factors are fixed, whereas in a dynamic overlapping generations frame,
where capital accumulation is affected by wages, such wisdom may be incorrect.
Indeed, in the paper we have showed that the regulation of wages could increase
both economic growth (i.e., the transitional rate of economic growth as well the
long-run per-capita income) and the lifetime welfare, on the one hand, and reduce
the fertility rate on the other hand. Therefore, we conclude that under suitable
conditions a regulated wage economy may perform better than a market-wage

123
Fertility, income and welfare in an OLG model with regulated wages 427

economy, and the level of the regulated wage may also be treated as a policy
parameter for the control of population growth. Moreover we note that, particularly
as regards underdeveloped as well as developing countries, where low wages, low
output per-capita, inadequate social protection systems and high fertility rates are
current stylised facts, our findings offer some interesting policy implications. The
interest of these results lies in: (1) the relevance of their messages showing a new
perspective for the regulation of wages, and (2) the simplicity with which they are
obtained, that is, within a standard dynamic general equilibrium overlapping
generations model where the departures from the textbook OLG frame are simply
the assumptions of endogenous fertility, regulated wages and balanced budget
unemployment benefit policies.
In particular, in contrast with the prevailing literature, we have shown that
introducing minimum wages in a simple one sector OLG framework may reverse the
correlation between unemployment and per-capita income, and the higher the long-
run unemployment rate the higher both the long-run output and the lifetime welfare.

Acknowledgments We thank an anonymous referee for helpful comments and suggestions.

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