Skill Formation and Inequality in Poor Countries: How Much do Ethnic Neighbourhoods Matter?

This paper explores the potential role of social learning in the process of skill formation. It develops a model in which parents form expectations about the future returns to schooling by observing the investment behaviour of other families in their neighbourhood. This model predicts that a child's educational attainment (and hence permanent income) depends not only on parental characteristics but also on the average level of human capital in the neighbourhood where the child grew up. Empirical support for the model is found using microdata from the 1994 Ethiopian Urban Socioeconomic Survey. The data reveal that social learning has large, significant effects which are positively correlated to both a child's future income and his (adult) stock of human capital. Perhaps most important, the inclusion of neighbourhood effects raises the steady-state standard deviation of education by 64%. Neighbourhoods have a slightly smaller effect on the rate of income convergence; they raise the steady-state standard deviation of income inequality by 54%.