Stochastic Dominance: Application

Stochastic dominance is applied in making decisions that present uncertainty and randomness. Economists use it mostly in predictions, delegation, and research involving situations whereby it’s hard to determine which economic function is accurate to use. However, it should be noted that application of the two primary criteria of stochastic dominance (First-Orders Stochastic dominance and Second-order stochastic dominance) is only applicable to selected comparisons and may be termed inconclusive in others. For instance, when more than two decisions have to be made, these criteria will not work. However, it can help to narrow down the options by eliminating the dominated alternatives.

Application in Real Economic Situations

As earlier mentioned, economists have applied stochastic dominance in making economic decisions over time. Application of this theory helps answer the following economic questions

• When making saving decision versus supply of labor and simultaneously considering the risk of saving. Does the supply of labor increase if the volatility of returns from saving increases?
• What happens to the supply of a competitive firm if random product prices increase? Will the risk be lower?
• How does diversifying a financial portfolio pay, and should one invest in an asset with higher returns or with less risk?
• When entering an oligopoly market. How is the probability of equilibrium entry change if any firms decide to enter the market? Is there a particular symmetric equilibrium applied in the mixed entry strategy?
• If all the agents of a society agreed to given ethical principle, would one succeed in unanimously ranking wealth distributions?