International Journal of Economic Theory

doi: 10.1111/ijet.12168

A minimum-wage model of unemployment and growth:

The case of a backward-bending demand curve for labor
Richard A. Brecher
and Till Gross

We add a minimum wage and hence involuntary unemployment to a conventional two-sector

model of a perfectly competitive economy with optimal saving and endogenous growth. Our
resulting model highlights the possible case of a backward-bending demand curve for labor,
along which a hike in the minimum wage might increase total employment. This theoretical
possibility complements some controversial empirical studies, in challenging the standard
textbook prediction of an inverse relationship between employment and the minimum wage.
Our model also implies that a minimum-wage hike has negative implications for both the growth
rate and lifetime utility.
Key words optimal growth, minimum wage, learning by doing, involuntary unemployment
JEL classification E24, O41

Accepted 15 May 2017

1 Introduction

This paper introduces a minimum wage and hence involuntary unemployment into the Ramsey–Cass–
Koopmans (Ramsey 1928; Cass 1965; Koopmans 1965) two-factor model of optimal growth over an
infinite horizon, as extended by Srinivasan (1964) and Uzawa (1964) to the two-good case.1 To avoid
an inherent problem of overdetermination, our minimum-wage model incorporates an endogenous
rate of growth,2 fueled by technological improvements due to learning by doing. Within this
framework, we investigate how a hike in the minimum wage affects employment, growth, and welfare.
Contrary to conventional academic wisdom, our analysis shows that a minimum-wage hike can
(under specified conditions) increase total employment, because of what may be called a backward-
bending demand curve for labor. Notably, this outcome is possible even though we consider a
perfectly competitive economy, in which firms are wage takers (not setters).3 This theoretical result

Department of Economics, Carleton University, Ottawa, Ontario, Canada. Email: [email protected]
We gratefully acknowledge helpful comments and suggestions from Lawrence F. Katz and an anonymous Associate Editor.
1
For an alternative approach to modeling growth with unemployment, see Cahuc and Michel (1996), who add a minimum
wage to an overlapping-generations model with only one good (produced in two technologically different sectors) and
three factors of production.
2
As discussed below, the minimum wage fixes (via the conditions for profit maximization) the interest rate, which then
determines the balanced-growth rate (needed to satisfy the household’s Euler equation). For an alternative solution to the
overdetermination problem in the absence of long-run growth, see Brecher et al. (2013).
3
It is well known that with wage-setting firms, minimum wages may increase employment, as first established by Stigler
(1946) in the case of a monopsonist. Alternatively, if firms set wages optimally for efficiency-wage reasons, Manning
(1995) shows that a minimum-wage hike may lead to a rise in employment. Flinn (2006) obtains this same result when the
wage is determined instead by bargaining in the presence of search and matching frictions.

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Minimum-wage model of unemployment and growth Richard A. Brecher and Till Gross

complements the controversial empirical findings of Card and Krueger (1995), in challenging the
simple textbook prediction of a negative relationship between employment and the minimum wage.4
We further demonstrate that the long-run rate of labor-augmenting technical progress is always
negatively related to the minimum wage. This result is in consonance with Acemoglu (2010), who
shows (among other things) how exogenous increases in the wage discourage innovation that raises
the marginal product of labor.5 However, his model does not allow him to analyze our case in which
a higher wage might be associated with more employment.
One might reasonably conjecture that lifetime utility could rise if a hike in the minimum wage
causes employment to increase. Our analysis, however, rejects this conjecture. Thus, any possible
gain in employment must be outweighed by the definite contraction in the rate of growth, within the
present representative-agent framework.6
Since our most surprising result is the possibility of an employment-expanding hike in the
minimum wage under perfect competition, here is a brief preview of the underlying intuition.
The wage hike lowers both the rate of return on capital and the growth rate, and hence may
reduce the rate of interest net of growth. In this case, demand shifts from investment to
consumption, thereby creating an excess demand for the consumption good and excess supply of the
capital good. If the former good is relatively labor intensive – an ‘‘assumption . . . often made in two-
sector models’’ (Acemoglu 2009, p. 395) – employment must increase to restore equilibrium.7
For simplicity of exposition, our analysis assumes only one type of labor, which is universally
subject to the minimum wage. However, we also explain how similar results can be derived when our
model is extended to include a second type, with a completely flexible wage.
Section 2 sets up the basic model, whose implications are explored in Sections 3 and 4 under
alternative assumptions about the source of learning by doing. In Section 5, we provide a numerical
example to illustrate the possibility of a backward-bending demand curve for labor. Section 6
concludes with a summary of our main contributions, and explains how they remain relevant under
an extension to include a second type of labor.

2 Basic model

Firms use capital and labor to produce capital itself and consumable output, which are called goods 1
and 2, respectively.8 The production function for each good is strictly quasi-concave, and exhibits
constant returns to scale, with positive but diminishing marginal products. Assuming that firms
maximize profits under perfect competition, we obtain the usual first-order conditions equating the
marginal product of labor (capital) to the real wage (rental) rate. The two goods can be uniquely
4
Empirical surveys by Schmitt (2013) and Neumark et al. (2014) are respectively favorable and unfavorable to the
Card–Krueger position.
5
Whereas our assumptions include learning by doing and optimal saving/investment, he assumes that firms choose
technology optimally, and that the stock of capital (or supply curve for this factor) is exogenously fixed.
6
Of course, this framework allows us to consider only efficiency, not equity. As shown by Boadway and Cuff (2001) and Lee
and Saez (2012), for example, a minimum wage might increase welfare for reasons related to interpersonal distribution.
7
An analogous two-sector mechanism can generate a backward-bending demand curve for labor in a static model with
heterogeneous consumers, as Brecher and Gross (2018) show. Via a different channel in a one-sector atemporal model,
Deltas (2007) demonstrates that a minimum wage may increase the number of labor hours employed, as workers raise
their perfectly observable level of effort (productivity) to avoid (involuntary) unemployment.
8
Alternatively, Bond et al. (2011) assume that the capital good is also consumable, giving rise to the possibility that either
good is inferior in their (full-employment) model. However, inferiority is not possible in our (minimum-wage) model,
because we assume instead that only one good is consumable.

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Richard A. Brecher and Till Gross Minimum-wage model of unemployment and growth

ranked according to their capital intensities per unit of labor, and there are no factor-intensity
reversals. Although all variables (such as consumption, outputs, inputs, prices, and assets) are
functions of time, the time argument t is suppressed for notational simplicity.
Along the production-possibility frontier, the output of good i is given by Qi ðp; K; LÞ 
Q ðp; K; lℓÞ for i ¼ 1, 2, where p stands for the relative price of good 1 in terms of good 2; K and ℓ
i

represent the economy’s inputs of capital and labor, respectively; l is the number of efficiency units
per natural unit of labor; and L  lℓ. Given constant returns to scale, the function Qi is first-degree
homogeneous in K and L. Thus, we can write

Qi ðp; K; LÞ  lqi ðp; k; ℓÞ  lℓ~qi ðp; ~kÞ; i ¼ 1; 2; ð1Þ

where k  K=l and ~k  k=ℓ.

To focus on the interesting situation in our two-good model, assume that the economy remains
diversified in production (with both Q1 > 0 and Q2 > 0) throughout the analysis. Then, because a
good’s output responds positively to a rise in its relative price, @Q1 =@p > 0 > @Q2 =@p.
Consequently, (1) implies that

q1p > 0 > q2p ; ~q1p > 0 > ~q2p ; ð2Þ

where subscripts of functions indicate partial derivatives (e.g. q1p  @q1 =@p and ~q1k  @~q1 =@~k).
By the Rybczynski (1955) theorem, Q1K > 0 > Q2K and Q1L < 0 < Q2L if good 1 is more capital
intensive (per unit of labor) than good 2, whereas the signs of these derivatives are reversed under the
opposite factor-intensity ranking.9 Thus, in light of (1),

j j j
qik > 0 > qk ; ~qik > 0 > ~qk ; qiℓ < 0 < qℓ , K i =Li > K j =Lj ; i; j ¼ 1; 2; ð3Þ

where K 1 and K 2 are the inputs of capital used by industries 1 and 2, respectively, while L1 and L2 are
the corresponding inputs of labor in efficiency units.
We also have the following three well-known facts:

pq1p þ q2p ¼ p~q1p þ ~q2p ¼ 0; q1k þ q2k =p ¼ ~q1k þ ~q2k =p ¼ r; pq1ℓ þ q2ℓ ¼ w; ð4Þ

where w is the real wage rate in terms of good 2 per efficiency unit of labor, and r represents the
interest rate, which equals the marginal product of capital in sector 1. The first fact in (4) holds
because the economy operates on the production-possibility frontier at the point where the marginal
rate of transformation equals the product–price ratio. The remaining two facts stem from
intersectoral equalization of each input’s marginal value product.
According to the Stolper–Samuelson theorem (Stolper and Samuelson 1941), a rise in the relative
price of a good is associated with a rise in the real return to the factor used intensively in this good,
and a fall in the other factor’s real return. Thus,

dp=dwO0; dr=dpP0 , K 1 =L1 PK 2 =L2 : ð5Þ

9
Although our model has only one country, we are able to take advantage of several results (including the Rybczynski
theorem) from the theory of international trade.

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Minimum-wage model of unemployment and growth Richard A. Brecher and Till Gross

Consumer behavior is consistent with that of a representative household, which competitively

maximizes the present discounted value of lifetime utility, subject to a budget constraint. Specifically,
this household maximizes
Z 1
V ert ln Cdt; ð6Þ
0

subject to

X_ ¼ rX þ wlℓ=p  C=p; ð7Þ

where r is the constant rate of time preference; C denotes total consumption (of good 2); the
instantaneous utility function is ln C, for simplicity of exposition;10 X stands for total wealth in terms
of good 1; and dots over variables indicate time derivatives (e.g. X_  dX=dt).
The only control variable for this maximization problem is C at each point in time. Although the
supply of labor is perfectly inelastic (with no disutility of effort), the household takes ℓ as given,
because of involuntary unemployment due to a binding minimum-wage constraint that fixes the
value of w. This value then determines p and hence r, via Samuelson’s (1949) one-to-one
correspondence between product and factor prices. Since the endowment of labor is normalized to
equal 1 by choice of units, the rate of unemployment is 1  ℓ.
Defining x  X=l and c  C=l, we can restate the household’s problem as maximizing
Z 1 Z 1
V ert ln cdt þ ert ln ldt; ð8Þ
0 0

subject to

x_ ¼ ðr  gÞx þ wℓ=p  c=p; ð9Þ

_
where g  l=l, which is the economy’s rate of growth due to technical progress of the labor-
augmenting (Harrod-neutral) variety. The current-value Hamilton for this maximization problem is
given by

H ¼ lnc þ ln l þ m½ðr  gÞx þ wℓ=p  c=p; ð10Þ

where the co-state variable m can be interpreted as the shadow price of assets. The necessary
conditions for a maximum include the following equations:

@H=@c ¼ 1=c  m=p ¼ 0; ð11Þ

m_ ¼ rm  @H=@x ¼ mðr þ g  rÞ; ð12Þ

in addition to the x_ constraint (9), as well as the usual initial and transversality conditions.
 
10
Our main results hold qualitatively for any utility function of the isoelastic form C1u  1 =ð1  uÞ, where the constant
u is greater than zero and equals the elasticity of the marginal utility of consumption, as well as the intertemporal elasticity
of substitution. As u ! 1, this function approaches ln C, which is the case that we adopt to simplify the exposition. For
reasons explained by Barro and Sala-i-Martin (1995, p. 64), an isoelastic type of utility function is commonly assumed for
consistency with a balanced-growth path.

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Richard A. Brecher and Till Gross Minimum-wage model of unemployment and growth

Since output of good 2 is fully consumed,

c ¼ q2 ðp; k; ℓÞ  ℓ~q2 ðp; ~kÞ: ð13Þ

From this equation and (11),

 
ℓ ¼ Zðp; k; mÞ; Z p ¼ 1=m  q2p =q2ℓ ; Z k ¼ q2k =q2ℓ ; Z m ¼ p=m2 q2ℓ : ð14Þ

We also have

K_ ¼ lq1 ðp; k; ℓÞ; ð15Þ

because all output of good 1 adds to the stock of capital. Then, differentiating kð K=lÞ with respect
_
to time (while recalling that g  l=l), we use (15) to obtain

k_ ¼ q1 ðp; k; ℓÞ  gk: ð16Þ

Assume that output-based learning by doing occurs in one industry, and spreads automatically
to the other industry, thereby causing (the economy-wide) l to increase over time.11 Specifically, l_
equals either lq1 ðp; k; ℓÞ or lq2 ðp; k; ℓÞ, as learning occurs in the capital- or consumption-good
sector, respectively. The first case is equivalent to learning by investing, an idea expounded originally
by Arrow (1962). The second case could be called learning by consuming, in the spirit of
Leibenstein’s (1957) hypothesis that a worker’s productivity depends on consumption for
nutritional reasons. We now consider each of these two possibilities in turn.

3 Learning by producing the capital good

If learning by doing occurs in the capital-good industry, l_ ¼ lq1 ðp; k; ℓÞ and thus

g ¼ q1 ðp; k; ℓÞ ¼ ℓ~q1 ðp; ~kÞ: ð17Þ

This assumption about the growth rate allows us to rewrite (12) as

m_ ¼ m½r þ q1 ðp; k; ℓÞ  r; ð18Þ

and (16) as

k_ ¼ q1 ðp; k; ℓÞð1  kÞ: ð19Þ

In steady-state equilibrium, m_ ¼ k_ ¼ 0. Then (18) and (19) imply the following two equations,
respectively:

11
Under these assumptions, balanced endogenous growth is consistent with perfect competition and constant returns to
scale. For an alternative way to achieve such consistency, see Bond et al. (1996).

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Minimum-wage model of unemployment and growth Richard A. Brecher and Till Gross

r ¼ r þ q1 ðp; k; ℓÞ ð20Þ

and (given q1 > 0 under our above assumption about diversified production)

k ¼ 1: ð21Þ

To determine the relationship between the minimum wage and national employment, substitute
(21) into (20), and differentiate the resulting equation totally with respect to p, thereby yielding
h i
dℓ=dp ¼ dr=dp  q1p ðp; 1; ℓÞ =q1ℓ ðp; 1; ℓÞ: ð22Þ

Multiply both sides of (22) by dp=dw, and use (3) with (5) to derive

dℓ=dw > 0 , dr=dp > q1p ðp; 1; ℓÞ: ð23Þ

In other words, we have the following result.

Proposition 1 A hike in the minimum wage increases the steady-state level of employment if and
only if a rise in the relative price of the capital good (ceteris paribus) has a smaller impact on this good’s
output than on the rental rate.

The necessary and sufficient condition in (23) may be satisfied if good 1 is capital intensive, since
(2) and (5) imply that q1p and dr=dp are both greater than zero in this case.12 However, under the
opposite factor-intensity ranking, dr=dp is less than zero, in which case the (necessary and sufficient)
condition in (23) cannot be satisfied. Thus, Proposition 1 describes a scenario that is possible only if
the capital good is more capital intensive than the consumption good.
For an intuitive understanding of Proposition 1, suppose that good 1 is relatively intensive in
capital. Then a minimum-wage hike lowers p, leading to a fall in r and  at the initial level of
employment – a drop in g ð¼ q1 ðp; 1; ℓÞÞ. If r falls more than g, there is a reduction in the net rate of
return r  g on capital per efficiency unit.13 This reduction tends to discourage saving and hence
encourage consumption. In fact, with employment temporarily held constant, c rises more than
q2 ðp; 1; ℓÞ, creating an excess demand for good 2.14 To clear this excess demand for the labor-
intensive good, employment must rise.
To determine the relationship between w and c, begin by using (12) and (16) with (1), while
setting m_ ¼ k_ ¼ 0 to obtain ~q1 ðp; ~kÞ ¼ ðr  rÞ~k. Then differentiate this equation totally with respect
   
to p, thereby yielding d~k=dp ¼ ~q1  ~kdr=dp = g  ~q1 . Thus, differentiating ~q2 ðp; ~kÞ totally with
p k
respect to p, while using (4), (17) and (20), confirm that
   
d~q2 =dp ¼ r p~q1p  ~k~q2k dr=dp = g  ~q1k :

12
As the elasticity of technical substitution (along an isoquant) approaches zero for both goods, so does q1p , but not dr=dp.
13 _
Since a rise in l tends to lower k ð K=lÞ, we can interpret g ð l=lÞ as a depreciation rate, and hence r  g as the net rate
of interest.
14
More formally, as r  g  r falls below 0, we have m_ > 0 by (12), hence c_ < 0 by (11), and thus x_ < 0 because (by well-
known reasoning) consumption depends positively on wealth. With x_ < 0, X=l _ ð¼ x_ þ xgÞ < q1 (since g ¼ q1 and
initially x ¼ k ¼ 1), implying X_ < Q1 . In light of this inequality and the instantaneous budget constraint
(pX_ þ C ¼ pQ1 þ Q2 ), clearly C > Q2 , indicating an excess demand for good 2.

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Richard A. Brecher and Till Gross Minimum-wage model of unemployment and growth

Figure 1 Phase diagram.

The numerator of this expression is positive because ~q1p > 0 by (2), while (3) and (5) imply that
~q2k
and dr=dp are always opposite in sign, no matter what the factor-intensity ranking of the two
goods. The denominator is positive or negative if good 1 is intensive in labor or capital,
respectively.15 Thus, from the sign of dp=dw in (5), it is clear that

d~q2 =dw > 0: ð24Þ

This condition and (13) imply the following result relating dc=dw and dℓ=dw.

Proposition 2 If (but not only if) a hike in the minimum wage raises the steady-state level of
employment, there is a corresponding rise in consumption per efficiency unit.

To see the minimum wage’s impact on the rate of growth, set m_ ¼ 0 in (12) and use this equation
to obtain dg=dw < 0, since dr=dw ¼ ðdr=dpÞdp=dw < 0 by (5). In other words, we have the
following result.

Proposition 3 A hike in the minimum wage unambiguously lowers the steady-state rate of growth.

To show that steady-state equilibrium is saddle-path stable, consider Figure 1, which is the phase
diagram for the dynamic system of (18) and (19). For the sake of concreteness, suppose that the
capital good is capital intensive, although the stability analysis would be essentially the same under
the opposite factor-intensity ranking.
The schedule for k_ ¼ 0 is a horizontal line at a height equal to 1, because of (21). The vertical
_ > 0 as k¼
arrows of motion point toward this line, to reflect the fact that k¼
<
1, in accordance with (19).
< >

15
In the former case, ~q1k < 0 by (3). In the latter case, set m_ ¼ 0 in (12) and use (4), to yield ~q1k ¼ r  ~q2k =p > r ¼ r þ g > g,
where the first inequality follows from the fact that now ~q2k < 0.

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Minimum-wage model of unemployment and growth Richard A. Brecher and Till Gross

By the following argument, the (generally nonlinear) schedule for m_ ¼ 0 is negatively sloped, and is
associated with horizontal arrows that point away from it.
To determine the sign of this schedule’s slope, differentiate (20) totally with respect to m (holding
   
p and hence r constant) while using (14) to obtain dk=dm ¼ pq1ℓ =m2 q2ℓ = q1k  q1ℓ q2k =q2ℓ . With this
   
equation, use (4) to find that dk=dm ¼ w  pq1ℓ pq1ℓ = wq1k  rpq1ℓ m2 q2ℓ < 0, where this inequality
follows from the signs of the Rybczynski derivatives in (3). In other words, the schedule for m_ ¼ 0 is
negatively sloped.
Starting from any point on this schedule, an increase in m (at constant k) would lower ℓ by (14)
and (3), thus raising output of capital-intensive good 1. The resulting increase in q1 would make
m_ > 0, in accordance with (18). Therefore, the horizontal arrows point away from the schedule for
m_ ¼ 0.
Beginning at any arbitrary point in Figure 1, m jumps instantaneously at time 0 to reach the
saddle path, represented by the dashed curve (generally nonlinear). Then the economy moves
continuously along this path toward the steady-state equilibrium, which corresponds to point S at
which the schedules for k_ ¼ 0 and m_ ¼ 0 intersect each other.
Let the schedules in Figure 1 correspond to the situation after a hike in the minimum wage.
Suppose also that the pre-hike economy is in steady-state equilibrium at point A, which must be on
the k_ ¼ 0 schedule, whose position (at the constant height of k ¼ 1) is independent of w. Then the
wage hike causes the economy to jump (via an instant change in m) to the new equilibrium at point S.
We therefore have the following result.

Proposition 4 A hike in the minimum wage causes the economy to jump immediately from the
initial to the new steady-state equilibrium.

Thus, the corresponding changes in total employment, aggregate consumption, and economic
growth (as described by Propositions 1, 2, and 3, respectively) all occur simultaneously with the wage
hike, without any transitional dynamics.
A possible rise in c (by Proposition 2) and definite fall in g (by Proposition 3) would affect
lifetime utility positively and negatively, respectively, since (8) can be rewritten as
Z 1 Z 1
V ert ln cdt þ ert lnðl0 egt Þdt ¼ ln l0 =r þ ln c=r þ g=r2 ; ð25Þ
0 0

where c and g remain constant at their steady-state levels, while l0 represents the value of l at the
instant when the wage hike occurs. However, regardless of whether the decrease in g is accompanied
by a fall or rise in c, Appendix A shows that dV=dw < 0 unambiguously. We thus have the following
result.

Proposition 5 A hike in the minimum wage definitely lowers the level of lifetime utility.

4 Learning by producing the consumption good

For this case, replace (17) by

g ¼ q2 ðp; k; ℓÞ ¼ ℓ~q2 ðp; ~kÞ: ð26Þ

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Richard A. Brecher and Till Gross Minimum-wage model of unemployment and growth

Proposition 3 and condition (24) still hold, because they are derived without the use of (17).
Thus, a minimum-wage hike lowers ℓ by (26) and reduces c by (13), contrary to Propositions 1
and 2, respectively.
Despite the replacement of (17) by (26), it is straightforward to show that the steady-state
equilibrium remains saddle-path stable, although the schedules for k_ ¼ 0 and m_ ¼ 0 become
negatively sloped and vertically linear, respectively. These schedule modifications imply that a hike in
the minimum wage changes the steady-state level of k. Thus, rather than switching instantly between
steady-state equilibria, the economy first jumps from the initial equilibrium to the new saddle path,
and then follows this path over time toward the new equilibrium.
In view of this dynamic process of adjustment, Proposition 4 no longer holds. Nevertheless, it is
possible (but tedious) to verify that Proposition 5 remains valid if the wage hike is small. Whether
this proposition similarly extends for a large hike is a technically challenging question for future
research. The challenge arises from the facts that the transition between steady states is not instant
in the present (unlike the previous) case, and the precise shape of the saddle path is difficult
(or impossible) to characterize outside the neighborhood of steady-state equilibrium.

5 Numerical analysis

This section provides a numerical example of the case in which a minimum-wage hike increases the
level of employment, assuming (for reasons suggested above) that technological progress occurs
through learning by doing in the capital-good sector, and that the consumption good is relatively
labor intensive. An important by-product of this exercise is to demonstrate the existence of a unique
steady-state equilibrium in our model, for each value of the wage within a specified range. Starting
from a position of full employment in the present example, successive hikes in the minimum wage
first decrease but then increase employment, illustrating what we call a backward-bending demand
curve for labor.16
To construct our example, we adopt a constant elasticity of substitution type of production
function for each industry. More specifically, suppose that

si
Y i ¼ ½ai K si i þ ð1  ai Þðlℓi Þs i 1=s i ¼ lℓi ðai~ki þ 1  ai Þ1=s i ; i ¼ 1; 2; ð27Þ

where Y i and ℓi ð Li =lÞ respectively denote output produced and (natural units of) labor employed
by sector i; ~ki  K i =lℓi ; ai and s i are constants; and 1=ð1  s i Þ is the elasticity of substitution
between capital and labor in production of good i.
Given constant returns to scale and perfect competition, we can think of a representative firm in
each industry. Subject to (27), this firm chooses K i and ℓi to maximize profits, given by

pi ¼ pi Y i  vlℓi  rK i ; i ¼ 1; 2; ð28Þ

where v  w=p, which represents the real wage in terms of good 1;17 pi is the nominal price of good i;
and p1  1 by choice of units (implying that v and r are also equal to the wage and rental rates in

16
Of course, this curve is a general-equilibrium (rather than Marshallian) one.
17
Although it is natural to specify the minimum wage in terms of the consumption good (as in previous sections), here both
factor rewards (v and r) are expressed in terms of the same (capital-good) units, for expositional convenience. Since the
Stolper–Samuelson theorem implies that dv=dw > 0, v can be used as a proxy for w without loss of generality.

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Minimum-wage model of unemployment and growth Richard A. Brecher and Till Gross

nominal terms, respectively). The first-order conditions for profit maximization are

s i 1
 s 1=s i 1
pi ai~ki ai~ki þ 1  ai ¼ r; i ¼ 1; 2; ð29Þ
i

si
pi ð1  ai Þðai~ki þ 1  ai Þ1=s i 1 ¼ v; i ¼ 1; 2: ð30Þ

Using (29) and (30) for sector 1 (while recalling that p1  1 by normalization), we respectively
obtain the following two equations:

h i
s 1 1=s 1 1
r ¼ a1 a1 þ ð1  a1 Þ=~k1 ; ð31Þ

~k1 s1 ¼ f½v=ð1  a1 Þs 1 =ð1s1 Þ  ð1  a1 Þg=a1 : ð32Þ

Combining (29) and (30) for sector 2, we can verify that

~k2 ¼ ½ðv=rÞa2 =ð1  a2 Þ1=ð1s 2 Þ : ð33Þ

In light of (31)–(33), the rental rate and capital–labor ratios in both sectors are each a function of v.
From growth definition (17), Euler equation (20) and production function (27) for sector 1, this
sector’s employment is

 s 1=s 1
ℓ1 ¼ ðr  rÞ= a1~k1 þ 1  a1 ; ð34Þ
1

which is a function of v (via r and ~k1 ). Then, v also determines each of the remaining variables:
k1  K 1 =l ¼ ~k1 ℓ1 ; k2  K 2 =l ¼ 1  k1 , given (21); ℓ2 ¼ k2 =~k2 ; and ℓ ¼ ℓ1 þ ℓ2 . Thus, for any
value of v, steady-state equilibrium (if it exists) is unique.

Figure 2 Backward-bending demand curve for labor.

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Richard A. Brecher and Till Gross Minimum-wage model of unemployment and growth

Figure 2 illustrates the wage–employment relationship for a particular set of parameter

values.18 As this diagram confirms, a backward-bending demand curve for labor is indeed
possible.19 Along the positively sloped portion of this curve, a hike in the minimum wage leads to
an increase in employment for the economy as a whole.

6 Conclusion

Our main contribution is a new mechanism whereby a minimum-wage hike can stimulate total
employment and hence reduce involuntary unemployment. This mechanism operates within a
standard two-sector model of optimal saving/investment, with endogenous growth due to learning
by doing. In this model, a hike in the minimum wage may reduce the net rate of interest adjusted for
growth, thereby creating an excess demand for the consumption good. If this good is relatively labor
intensive, total employment must rise to restore equilibrium, along a backward-bending demand
curve for labor. Regardless of what actually happens to employment, we also show that the
minimum-wage hike has negative implications for both the growth rate and lifetime utility.
Although these contributions are made in a framework with only one type of labor, they are
robust enough to remain relevant when the model is extended to include a second type, which stays
fully employed because it is not subject to a minimum wage. In one such extension, the
representative agent has fixed endowments of both skilled (flexible-wage) and unskilled (minimum-
wage) labor, the learning-by-doing process uniformly augments the efficiency of both types of labor,
and each unit of skilled labor is a perfect substitute for a fixed amount of unskilled labor. In this
simple case, all of our equations and diagrams remain unchanged, except for minor
accommodations regarding notation and choice of units. More generally, when the two types of
labor are not perfect substitutes, the analysis becomes more complicated, but yields similar results
under some reasonable specifications. For instance, if capital and skilled labor are first used to yield
an intermediate input, which then combines with unskilled labor to produce the two goods, our
main results can still be derived (mutatis mutandis).

Appendix A

From (25),

dV=dp ¼ ðdc=dpÞ=cr þ ðdg=dpÞ=r2 : ðA1Þ

After differentiating (13) totally with respect to p, use (4), (21) and (22) to obtain

dc=dp ¼ ðq2ℓ dr=dp  wq1p Þ=q1ℓ : ðA2Þ

18
For diagrammatic clarity, these values are r ¼ 0:04, a1 ¼ 0:6, a2 ¼ 0:2, s 1 ¼ 1:5, and s 2 ¼ 25. Nevertheless, a similar
illustration (but with a less pronounced backward bend) can be generated for higher values of s 1 and s 2 , implying greater
elasticities of technical substitution. For example, Figure 2 would remain qualitatively the same if instead r ¼ 0:04,
a1 ¼ 0:35, a2 ¼ 0:45, s 1 ¼ 0:1, and s 2 ¼ 4. A full-blown calibration, however, is beyond the scope of the present
paper.
19
Below this curve’s lower bound (where ℓ ¼ 1), the minimum wage is not a binding constraint. Above the curve’s upper
bound, the interest rate would be less than the rate of time preference, implying (absurdly) a negative output of good 1 in
(20). Although Minhas (1962) shows that factor-intensity reversal must occur at some wage–rental ratio when constant
elasticities of technical substitution differ between industries, the first good in the present example is always more capital
intensive than the second between the above-mentioned bounds.

International Journal of Economic Theory xxx (2018) 1–13 © IAET 11

Minimum-wage model of unemployment and growth Richard A. Brecher and Till Gross

From (17) and (20),

dg=dp ¼ dr=dp: ðA3Þ

Substituting (A2) and (A3) into (A1) yields

h  i
dV=dp ¼ q2ℓ =q1ℓ q2 þ 1=r dr=dp  wq1p =q1ℓ q2 =r; ðA4Þ

after using (13).

Note that

q2ℓ =q1ℓ ¼ ðq2 =k2 Þ=ðq1 =k1 Þ; ðA5Þ

because the ratio of Rybczynski derivatives for labor equals minus the ratio of average products for capital.20 Since capital is
fully utilized, (21) can be rewritten as

k1 þ k2 ¼ 1: ðA6Þ

Substitute (A5) and (A6) into (A4), multiply both sides of the resulting equation by dp=dw, and use (20) to verify that
n  
dV=dw ¼ 1  r= q1 =k1 ðdr=dwÞ=rk2  wq1p ðdp=dwÞ=q1ℓ q2 g=r: ðA7Þ

Since the average product of each factor exceeds its marginal product,

q1 =k1 > r: ðA8Þ

From (5),

dr=dw < 0: ðA9Þ

It is also true that

q1ℓ dp=dw > 0; ðA10Þ

from (3) and (5).

Using (A7)–(A10) and (2), we see that

dV=dw < 0: ðA11Þ

This confirms Proposition 5.

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