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The effect on economic outcomes of ethnic diversity remains debatable. Some view ethnic diversity as a deterrent of development, whereas others consider it a source of innovation and productivity, which can be translated into a higher level of development. This study aims to shed further light on the issue. Applying instrumental variables estimation to district‐level data, we find that ethnic diversity has a significant positive association with nighttime light intensity, which is used as a proxy for level of economic activity. The finding is robust to alternative specifications. Our finding suggests that centuries of interethnic contacts and coexistence may have helped ethnically diverse communities to gain experimental knowledge of the diverse beliefs and social practices and transition it into better economic outcomes.

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A unique dataset is used to uncover one mechanism generating regional and ethnic inequality in Ethiopia. Individual banks’ location decisions depend on the degree of similarity between the ethnic composition of each locality and the ethnic composition of the bank’s board of directors. Using ethnic similarity as an instrument for bank location and climate as an instrument for economic development, we model both local banking provision and local economic development. Our model predicts that if the ethnic composition of all boards reflected the national population, then banks would have an incentive to operate in a wider range of locations.