Social interaction is an important vehicle of human capital acquisition and its efficiency decreases in social distance. In this paper I establish that these two premises, given the socio-cultural differences between ethnic groups, explain the puzzling evidence that (i) minorities typically earn less than majorities and (ii) this earnings gap is increasing in the relative size of a minority in a given region. In particular, I argue that inter-ethnic social distance disadvantages smaller ethnic groups in human capital acquisition and that these efficiency differentials systematically expose minority and majority individuals to different incentives as concerns their choice of skills. As a result, minority and majority individuals tend to acquire different (combinations of) skills and the textbook substitution effect drives an efficiency unit of minority labor to sell at a relatively lower wage in a region with higher percentage of minority people. The conditions under which the efficiency disadvantage of the minority in social interaction and the substitution effect explain the abovementioned empirical findings are established. In addition, this study offers an answer why some minorities earn more than majorities, why minority individuals tend to spend more time socializing in families than in schools, and why integration may harm minorities.
human capital earnings inequality labor market minority network externalities social interaction ethnic specialization