Risk Aversion, Stochastic Dominance, and Rules of Thumb: Concept and Application Vivek H. Dehejia Carleton University and CESifo Email: vdehejia@ccs.carleton.ca January 14, 2008 JEL classification code: D81 Consider the following generic and fairly narrowly defined choice problem. An individual must choose from amongst a discrete and finite set of lotteries. Suppose for concreteness that each lottery represents a monetary payoff, and that all the lotteries are constructed so as to be comparable. As a running example, the lotteries could represent incomes in different countries in given years, and comparability could be ensured, at least in principle, by converting to a common metric using inflation- and purchasing power parity-adjusted exchange rates. Each lottery is characterized by a corresponding distribution function, that is known with certainty. The uncertainty arises because, if the individual picks a particular distribution, he will receive a payoff that is a random draw from that distribution. How is he to choose amongst these lotteries? Assuming that his preferences are such that they admit of a Von Neumann- Morgenstern (VNM) expected utility representation greatly simplifies the problem. Now, the individual will pick the lottery that gives him the maximum level of expected utility. If the individual is risk-neutral, so that his expected utility function is linear in the monetary payoff, the problem is not especially interesting. From conventional economic theory, we know that maximizing expected utility in this case will reduce to maximizing the expected payoff, given the linearity of the expectation operator. The individual will simply pick the lottery that has the highest corresponding expected value, assuming, as I shall do throughout, that this (as all other relevant moments) exists and is well-defined for all the lotteries. In our example, this would involve picking the country whose income distribution has the highest mean income, i.e., income per capita. 1