The Impact of Ethnic Fractionalization on Labor Productivity : Does Firm Size Matter?

Ethnic fractionalization has both positive and negative consequences. It is contended that thepositive effects due to skill complementarity in the production process apply to large firms that have morecomplex and diversified production structures. Because small businesses rely more on public goods and have less access toinstitutions, the negative effects of lower quality public goods and higher transaction costs have a greater impact onthem. Consistent with this viewpoint, it is found that a larger firm size significantly mitigates the negative impactof higher ethnic fractionalization on the level and growth rate of labor productivity in manufacturing firms across 84developing countries. There is no robust and significant impact of ethnic fractionalization on large firms for themain and most of the other firm size categorizations considered. The results are confirmed by the instrumentalvariables estimation method, which uses the duration of early human settlement in each country to instrument ethnicfractionalization. Evidence is provided on the potential mechanisms by which ethnic fractionalization affects smallversus large firms. The findings have significant policy implications, which are discussed in detail.