Working Paper, Department of Economics, Uppsala University 2013:7
In Rawls' (1971) influential social contract approach to distributive justice, the fair income distribution is the one that an individual would choose behind a veil of ignorance. Harsanyi (1953, 1955, 1975) treats this situation as a decision under risk and arrives at utilitarianism using expected utility theory. This paper investigates the implications of applying prospect theory instead, which better describes behavior under risk. I find that the specific type of inequality in bottom-heavy right-skewed income distributions, which includes the log-normal income distribution, could be socially desirable. The optimal inequality result contrasts the implications of other social welfare criteria.
veil of ignorance prospect theory social welfare function income inequality