How does the level of cultural diversity at the time of community formation affect the development of formal and informal institutions? Do social differences between diverse and homogeneous communities have divergent economic implications in different institutional contexts? I argue that diversity not only impedes informal mechanisms of cooperation, but also increases reliance on formal legal institutions, which, in turn, can have positive economic implications. While informal norms and networks in homogeneous communities can sustain local provision of public goods in the absence of public authority, it is the predominance of formal law and state enforcement that enables arm's length transactions in developed market economies. And because institutional equilibria are path dependent, greater reliance on formal institutions in diverse communities may lead to a wealthier and more entrepreneurial society in the long run.
I evaluate this theory using an original historical dataset on the size and diversity of migrant groups settled in 1,217 municipalities transferred from Germany to Poland in 1945, collected during a year of fieldwork funded by the Social Science Research Council and Harvard Center for European Studies. I show that homogeneous migrant groups were more successful in reestablishing traditional private-order institutions that relied on informal enforcement mechanisms, such as volunteer fire brigades, while diverse migrant communities relied on the state for the provision of public goods and enforcement of cooperative behavior. The greater role played by formal institutions in diverse communities provided no tangible economic benefits during state socialism, when private property was poorly protected and individual economic activity heavily restricted. When Poland transitioned to a market economy in 1989, however, the fortunes of homogeneous and diverse communities began to diverge. Today, communities settled by diverse migrant groups in the 1940s not only express greater confidence in formal institutions and related organizations, such as the courts, banks, and the police, but also have higher incomes and more private enterprises per capita. Entrepreneurs in historically more diverse communities also report fewer obstacles to doing business than their counterparts in more homogeneous communities.
This project challenges the predominant view of diversity as harmful to economic development and suggests that in the long run, a society can minimize the costs and maximize the benefits of diversity by adopting appropriate institutional mechanisms. It also provides a more nuanced view on the relevance of social capital by showing that informal norms and networks may be a poor substitute to formal institutions in developed market economies. These insights into the development of institutions in the context of a large and diverse population inflow could inform policy interventions at a time when the Middle East, North Africa, and Europe are struggling to cope with an influx of refugees from war-torn regions.