The illusory correlation model of stereotype formation proposes that stereotypes can arise from the tendency to overrepresent distinctive behaviours performed by minority groups. However, recent studies suggest that when stimulus groups are meaningful the effect may be overridden by ingroup favouritism. This paper addresses the question of whether or not ingroup favouritism is itself the manifestation of a social bias that permeates the formation of all stereotypes. An illusory correlation experiment is reported where stimulus groups are identified as coming from different pairs of cities (Canberra, Perth, and Detroit; N = 130). Here ingroup favouritism gives way to a “black-sheep effect” (Marques, 1990) when a negative ingroup exemplar is compared with an outgroup. This finding is inconsistent with a simple ingroup bias model, but consistent with social identity theory which suggests that manifestations of favouritism are sensitive to comparative and normative features of social context. Implications for models of stereotype formation are discussed.