We study diversity policies such as affirmative action in college admission in the presence of local peer effects. If students are constrained in making side payments within peer groups, the free market allocation displays excessive segregation relative to the first-best, generating excessively disparate pre-college investments. Effective diversity policy must overcome market forces within as well as across college boundaries. Policies that engender diversity affect pre-college investment incentives. 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 student cross-subsidization by colleges.