Instrument effects and stochastic dominance (Q1118313)

This paper investigates how individual choice is affected by increases in risk when the choice variable (instrument) affects the distribution of the random variable as well as the objective function. The effect of increased risk on optimal choice is shown to depend on attitudes towards risk and the interaction between exogenous uncertainty and the instrument. The latter is described in terms of an extension of the notion of stochastic dominance to a comparison of changes in probability distributions (signed measures) rather than the direct comparison of distributions (probability measures). Sufficiency conditions for signing comparative statistics exercises are presented and applied to an insurance example involving moral hazard.