EDUCATIONAL VOUCHERS WHEN THERE ARE PEER GROUP EFFECTSÐSIZE MATTERS* BY ELIZABETH LIZABETH M. CAUCUTT AUCUTT 1 University of Rochester, U.S.A. In this article, I study the effects various educational voucher policies have on the sorting of children across schools and the per-student expenditure levels at these schools, when a child's peer group matters and students differ over income and ability. I ®nd that, depending on the magnitude of the voucher, switching from a public system to a voucher system could entail either welfare gains or losses. All voucher policies under consideration lead to greater inequality than the public system; however, these increases are not monotone in the voucher size. 1. INTRODUCTION INTRODUCTION Several states are considering enacting or have enacted educational voucher plans, which entail giving parents money to send their children to private schools. Both the cities of Milwaukee and Cleveland have started educational voucher programs. During the 1996±1997 school year, around 1650 students in Milwaukee received vouchers worth $4400, at a total cost of over $7 million. In the same year, Cleveland spent $6.4 million, distributing an average voucher of around $2000, to 1996 students. Other smaller scale voucher plans have sprouted up in school districts around the country. Proponents claim vouchers give poor parents educational choice for their children and give poor children a chance to succeed where the public schools fail them. Opponents argue that by funding vouchers, resources will be funneled out of the public schools to a small number of students and that the majority of students who are left behind in the public schools will suffer. In order to evaluate these proposals, a framework is needed that incorporates the factors important to educational outcomes. Along with family background and educational expenditure, many empirical studies have shown that the peer group plays a signi®cant role in educational achievement. Consider a change in educational policy, for example, adopting a voucher system. Such a switch will affect not only  Manuscript submitted August 1999; revised February 2000. 1 I greatly appreciate the comments of Raquel Fernandez, Rick Hanushek, Antonio Merlo, Edward Prescott, Richard Rogerson, Richard Romano, and an anonymous referee. Of course, any errors are mine. Please address correspondence to: Elizabeth M. Caucutt, Department of Economics, University of Rochester, 238 Harkness Hall, Rochester, NY 14627-0156. Phone: 585-275-0093. Fax: 585-256-2390. E-mail: Caucutt@usc.edu; ecau@trai.cc.rochester.edu. INTERNATIONAL ECONOMIC REVIEW Vol. 43, No. 1, February 2002 195