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