Apportioning of risks via stochastic dominance
Consider a simple two-state risk with equal probabilities for the two states. In particular, assume that the random wealth variable dominates via ith-order stochastic dominance for i=M,N. We show that the 50-50 lottery dominates the lottery via (N+M)th-order stochastic dominance. The basic idea is that a decision maker exhibiting (N+M)th-order stochastic dominance preference will allocate the state-contingent lotteries in such a way as not to group the two "bad" lotteries in the same state, where "bad" is defined via ith-order stochastic dominance. In this way, we can extend and generalize existing results about risk attitudes. This lottery preference includes behavior exhibiting higher-order risk effects, such as precautionary effects and tempering effects.
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