College diversity policy and investment incentives

We study college diversity policies in the presence of local peer effects and pre-college investments. If students are constrained in the side payments they can make within peer networks, the free market allocation displays excessive segregation and investment disparity compared to the first-best. Effective diversity policy must overcome market forces both within and across college boundaries, combining admission and association policies. When based on achievement, policies can increase aggregate investment and income, reduce inequality, and increase aggregate welfare relative to the market outcome. They may also be more effective than cross-subsidization schemes.