Collective Reputation and the Dynamics of Statistical Discrimination

Economists have developed theoretical models identifying self-fulfilling expectations as an important source of statistical discrimination in labor markets (Arrow, 1973). The static models dominating the literature of statistical discrimination, however, may leave the false impression that a bad equilibrium is as fragile as a "bubble" and can burst at any moment when expectations flip. Such models thus understate the adversity that disadvantaged groups face in seeking to escape bad equilibria. By developing a dynamic version of a statistical discrimination model based on Coate and Loury's (1993) original setup, we clarify the limits of expectations-related fragility. We show that when a group is strongly affected by negative reputational externalities, the group cannot escape a low skill investment trap, regardless of how expectations are formed. By examining the evolution of stereotypes in this way, we also provide new insights into egalitarian policies.