Transcript FUNDAMENTALS OF ISLAMIC ECONOMCS

ISLAMIC ECONOMCS
IBF 6111
Topic 6 & 7
Consumption and Production in Islam
CONTENTS
1. Introduction
2. Consumption in Islam and the hierarchy of needs
3. Consumer choice and the allocation of resources
in Islam
4. Production in Islam: Factors of production and
factor payments
5. Entrepreneurship and production in Islam: factor
pricing
6. Efficiency of resource allocation
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1. Introduction
3
INTRODUCTION
• In economic theory, people perform two primary functions
within the market. These functions or roles are
consumers and producers.
• In this topic, we will begin by differentiating between
maslahah (in the public interest) and utility (‘satisfaction’)
in terms of consumer behaviour, and the decision making
process in terms of consumer choice and the allocation
of resources.
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INTRODUCTION (Cont.)
• Subsequently, we will turn to production and begin by
differentiating between the factor of production and their
payments, and how factor pricing is determined with
entrepreneurial production in Islam.
• Finally, we discuss the efficiency of resource allocation
in terms of the marginal efficiency of capital (or
investment) financed by either by debt at interest or
equity and profit-sharing.
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2. Consumption in Islam and
the hierarchy of needs
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UTILITY THEORY OF VALUE
• In secular economics, the utility theory of value replaced the
classical labour theory of value during the marginal revolution
of the 19th century, in the publications of Jevons (The Theory
of Political Economy, 1871), Menger (Principles of Economics,
1871), Walrus (Elements of Pure Political Economics, 1874).
• Later Böhm-Bawerk produced a theory of interest based upon
the interaction of diminishing marginal utility and diminishing
marginal productivity of time with time preference (The
Positive Theory of Capital, 1889).
• Marginalism, or the marginal utility associated with the
maximization of utility and profit, were considered the sole
determinants of rationality, the self-interested pursuit of
unlimited wants and wealth which is the hallmark of secular
materialism we find in capitalism and mainstream economics
that developed from classical economics.
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THEORY OF
CONSUMER BEHAVIOUR
• Utility-maximization: from secular point of view the theory of
consumer behaviour uses the law of diminishing marginal
utility to explain how consumers allocate their income.
Consumer choice and the budget constraint.
• Consumers are assumed to be rational, i.e. they are trying to
maximize their utility with the budget they have.
• Consumers have clear-cut preferences for various goods and
services and can judge the utility they receive from
successive units of various purchases.
• The determinants of a consumer purchasing goods include,
tastes (or pattern of preferences); income (ability to buy); and
choice (willingness to buy).
• How much would a consumer be willing to pay for the
consumption of each successive Big Mac at McDonalds?
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UTILITY THEORY OF
VALUE AND THE
INDIFFERENCE CURVE
• Indifference analysis reveals
optimal utility, and the marginal
rate of substitution, is where the
indifference curve is tangent with
the budget constraint curve.
• When P increase for product B
from $1.00 to $1.50, the
equilibrium between what a
customer prefers and what he can
afford shifts from X to X’,
decreasing the quantity of product
B demanded from 6 to 3 units.
• The demand curve is determined
from the $1:6 units, and $1.5:3
unit combinations.
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MUSLIM CONSUMER BEHAVIOUR
• However, a Muslim consumer must first think of his
obligation to Allah (s.w.t) in terms of how much of the
income is to be spent on worldly needs and how
much to spend in the way of Allah (infaq fi sabil
Allah)…
• Have I paid my zakat yet?
• Do I wish give in a charitable cause for the sake of
Allah (s.w.t.)?
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MODERATION IN CONSUMPTION
• Only then will a Muslim think about planning for
consumption or saving, and when consuming, doing
so in moderation.
• “Those who, when they spend, are not extravagant
and not niggardly, but hold a just (balance) between
those (extremes)” (Al-Furqan, 25:67).
• According to Imam Ghazali, “the sustenance of a
number of the sahabah was no more than a sa’ of
wheat every week” (Ihya, 2004, 3, pp.87-87, Bk.23
Kitab Kasr al-Shahwatayn - Book of Breaking the Two
Desires).
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NEEDS AND WANTS
• Islam recognizes that man has certain needs, some
of which are more important and others less
important. The Shari’ah emphasizes that one’s
preference might not coincide with one’s true utility
function.
• “The economic problem revolves around mankind’s
needs, the means of their satisfaction and utilizing
these means” (An-Nabhani, 2002:47).
• Limited needs can be fulfilled, but not unlimited
wants. (Zaman, 2010:88).
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3. Consumer choice and the allocation of
resources in Islam
13
THE HIERARCHY OF
MUSLIMS’ NEEDS
• Al-Dimashqi (The Guide to the Merits of Commerce, AlIsharah Ila Mahasin Al-Tijarah, 570H/1175) classified needs
(al-hajat) as essential (daruriyyah) and others which are
socially incidental (‘aradiyyah wad’iyyah).
• Abu Ishaq al-Shatibi (Maliki, d.790H/1388) described five
fundamentals of existence in this world: (1) life (nafs); (2)
property (mal); (3) faith (din); (4) reason (‘aql); (5) posterity
(nasl).
• Goods and services that promote these five elements are
said to have maslahah for humans and are therefore
needs, which can be classified into three groups:
• Daruriyyat (Necessitates)
• Hajiyyat (Conveniences)
• Tahsiniyyat (Refinements / Beautification)
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ALLOCATION OF RESOURCES
TO NEEDS IN ISLAM
• Maslalah would act in the best interests of man.
• Utility or satisfaction implies a wider meaning that would
be subject to individual behaviour.
• Resources should be first allocated to the essentials or
daruriyyat, and if any balance left over then to hajiyyat,
then to tahsiniyyat.
• This involves first level of preference ordering akin to
lexicographical ordering which cannot be represented by
convex indifference curves that neo-classical economics
assumes for preference ordering (Khan, 1995:37).
• Islamic consumer behaviour involves an Analytic Hierarchy
Process (AHP).
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DECISION MAKING PROCESS
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EFFICIENCY
• Islamic theory of of consumer behaviour considers 4 levels of
consumer choice.
• Secular economics restricts itself to the 2nd and to the 4th levels,
choosing to ignore the 1st and the 3rd level.
• In the 4th level in secular economics, choices between
substitutes are applied but only partially, without recourse to
maslahah -v- utility, or indeed praiseworthy or blameworthy.
• Therefore, the scope of consumer behaviour in Islamic
economics is much larger than in secular economics.
• In terms of consumer choice for allocations of resources, the
concept of secular efficiency is to maximize satisfaction with
available resources.
• Islamic efficiency is to maximize the fulfillment of needs with
available resources.
• Fulfilling needs is desirable, it is desirable that necessities are
met as a first priority; those that have more than this are required
to meet the necessities of those who do not.
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ISLAMIC -v- CONVENTIONAL CONSUMER
BEHAVIOUR IN THE MARKET PLACE
• Conventional concept of consumer behaviour rests on a
persons utility function, but Islamic consumer behaviour
rests on Allah’s pleasure in term of spending to help
others (alms).
• Conventional consumer behaviour focuses on
consumption for worldly needs only, but in Islam
consumer behaviour looks on both the worldly needs
and the hereafter.
• Consumer behaviour in the conventional system is free
to consume any product according to his desire or whim,
but in Islam it is bound by moderation and Islamic
morals and ethics.
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AL-GHAZALI
• Consumption and consumer behaviour
• “The object of the wise is the vision of the Lord in the next world and the
only way to gain it is learning and action and there is no other way, but it
is not possible to stand constantly on them without a health body which
is also not possible without food and drink, such food and drink which
are absolutely necessary and which are taken according to prescribed
rules”
• Ihya, 2004, 2:1, Bk.11 Kitab Adab al-Akl (Book of the Manners Relating to Eating)
• “The sustenance of a number of the sahabah was no more than a sa’ of
wheat every week. When they ate dates they sufficed themselves with
one sa’ and a half. One sa’ of wheat is four mudds, so that each day
they ate about half a mudd, a third of the stomach. A greater quantity
was required in the case of dates because these contain pits which must
be discarded. Abd Dharr (r.a.) used to day, ‘every week my food
amounts to one sa’ of barley, in accordance with the usage of the
Apostle of Allah (s.a.w.s.), and, by God, I shall not eat more until I meet
him again!”
• Ihya, 2004, 3:87-87, Bk.23 Kitab Kasr al-Shahwatayn (Book of Breaking the Two Desires)
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4. Production in Islam:
Factors of production and factor payments
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FACTORS OF PRODUCTION FROM
ISLAMIC PERSPECTIVE
• Differences of opinion exist between conventional
economists and Islamic economists as to the composition
of the factors of production.
• In the Islamic framework we can identify hired factors of
production which claim ujrah (rent or wages); and
entrepreneurial factors of production which claim ribh
(profits) (Khan, 1995:140).
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ISLAMIC FRAMEWORK FOR FACTORS
OF PRODUCTION
• In an Islamic framework, factors of production can be identified
according to their functions;
– Hired factors of production (HFP) that provide a productive
service for which they are entitled to receive a definite reward
(wages or rent).
– Entrepreneurial factors of production (EFP) that choose to bear
the risk of an entrepreneurial project rather than receive a fixed
wage or rent.
– HFPs are derived from resources which could also offer
themselves as EFPs. The supply & demand for HFPs thus
competes with the supply and demand for EFPs. All resources
have to opt for HFP and ujrah or EFP and ribh.
– Money cannot be an HFP but can serve as an EFP if it bears
risk; EFP implicitly recognizes money in the Islamic economic
system as a factor or production to the extent that it is capable
of bearing risk and entitled to profit as with physical capital and
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human resources (labour).
ECONOMIC RESOURCE AND RESOURCE
PAYMENTS
CONVENTIONAL
ECONOMIC RESOURCE
SECULAR
RESOURCE
PAYMENT
LAND: natural resources
RENT
LABOUR: skilled &
unskilled labour
WAGES
CAPITAL: man-made
resources (machines,
buildings, equipment)
INTEREST
ENTREPRENEURIAL
ABILITY: human resources
that combine land, labour &
capital - organizes and
produces output
PROFIT
ISLAMIC ECONOMIC
RESOURCE
ISLAMIC
RESOURCE
PAYMENT
HIRED FACTORS OF
PRODUCTION: land,
animals, human resources
(skilled & unskilled labour),
buildings, other goods for
usufruct
UJRAH
(WAGES OR
RENT)
ENTREPRENEURIAL
FACTORS OF
PRODUCTION: combining
human resources and nonhuman resources (physical
capital or money) in a
productive economic venture
RIBH
(PROFIT)
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CONVENTIONAL RESOURCES AND
RESOURCE PAYMENTS
• Conventional economics does not regard money capital as a
separate factor of production, but recognizes interest as the
reward for capital.
• The interest rate is regarded as the price of money capital but
is treated as representing also the price of physical capital.
• Even land and rental may be priced at interest as a trade-off
between a fixed return from financial assets (such as fixed
deposits or government bonds): P = R / r, if rental is $1000
and interest is 10%, the P = 1000 / 0.1 = 10,000.
• In secular theory, money is deemed a commodity that can be
traded in the money market and rented out at interest; but in
Islam money cannot be rented.
• In Islam, money is an instrument of transfer only, and the
financial market for capital for monetary resources is a real
sector and not just a money-market.
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ISLAMIC FACTOR MARKETS
• With regard to the factors of production and factor
markets, the theories of the supply and demand of
labour and capital in Islam are not dramatically different
from conventional economics, except;
– The rental of capital goods on ijarah should be on the basis
of operating leases not financial leases, real rental is the
price of a real service not pegged to an interest rate.
– Marginal productivity will determine the demand for human
resources and physical capital to be employed on an ujrah
basis.
– The supply of capital is not a function of savings and a
choice between present or future consumption, and so has
no link with an interest rate, but rather the supply of capital
is determined by the opportunity cost of producing capital
goods.
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PRODUCTION IN AN ISLAMIC SOCIETY
• Islam stipulates and encourages tijarat kasb al-halal,
(lawful trade) in other words Islam recommends
certain norms of behaviour in the market while
seeking profit.
• Islam has discouraged any entrepreneur to borrow at
interest, and at the same time has encouraged
business through trade.
• Islam has recommended the khalifah to observe
certain norms of behaviour while dealing in business
transactions.
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HIERARCHY OF PRODUCTION AND
PRODUCTION ACTIVITIES
• Imam Ghazali commented on the various kinds of production
activities, including their hierarchy.
• He considers economic pursuits as part of an individual’s worship
(Ihya, 2:61), and the production of necessities as a socially obligatory
duty (Ihya, 2:83).
• The State must assume responsibility to ensure that necessities are
produced in sufficient quantities.
• He classifies a hierarchy of primary (agriculture), secondary
(manufacturing) and tertiary (services) production activities into three
broad groups (Ihya, 1:12,13,16);
• Basic industries: important to sustain life - agriculture (food);
textiles (clothing); construction (shelter) and infrastructure to
facilitate production of necessities.
• Ancillary activities: basic industries - iron industry; mineral
extraction; forestry resources.
• Complimentary activities to basic industries, such as the
grinding and baking of agricultural products.
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STATE ENCOURAGEMENT OF
PRODUCTION AND PRODUCTIVITY
• Early precedents of economic activities and the state involve
the state extending financial help to farmers to encourage
production and productivity;
• Yahya reported that Umar II wrote, “Look into the the state
lands in your province and distribute them on the condition of
share-cropping at half of the yield or even less, reducing the
state’s share to one tenth. However, if the land is so infertile
that nobody likes to cultivate it even at one tenth, give it for
nothing. If even then there is nobody to accept it, spend on its
cultivation from the public treasury so that no land under your
control is neglected.” (Yahya, 1979:63).
• Abu Ubayd reported that Umar II ordered one of his governors
to extend loans to the farmers for the development of land
(Abu Ubayd, 1986:265)
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5. Entrepreneurship and Production in Islam:
Factor Pricing
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SECULAR THEORY OF PRODUCER
BEHAVIOUR
• Profit Maximization: for producers, the economic problem is to
maximize profits. The key decisions are which outputs to
produce, how much of each output to produce, and which inputs
to use to produce the outputs.
• The indifference curve solves the utility-maximizing problem of
consumers, and in a firm that is maximizing profit, the
production isoquant also deals with the cost-minimization
problem of producers, revealing the technological tradeoff
between capital and labor in the production function, and the
decreasing marginal returns of both inputs.
• Adding one input while holding the other constant eventually
leads to decreasing marginal output, and this is reflected in the
shape of the isoquant.
• The production function is an engineering relation that defines
the maximum output (Q) from a given set of inputs, namely
capital (K) and labour (L): Q = f (K, L).
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SECULAR UTILITY THEORY OF VALUE
ALSO APPLIES TO PRODUCTION
• Optimality with the production isoquant, reveals the ability of the firm to
substitute two different inputs (e.g. labour & capital) in order to produce
the same level of output Q.
• The optimal marginal rate of technical substitution is where the isoquant
is tangent with the isocost curve (‘iso’ in Greek means ‘equal’).
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OPTIMALITY
• Optimality also applies to the production possibilities curve,
which reveals optimal efficiency including output, revenue
and profit.
• In terms of resource allocation, Pareto-optimality, defined
as an attained optimal ‘point’ that cannot be changed
without making anyone worse off, results in competition
between alternatives: not only competing goods, labour
and capital, but competing social groups, political
opponents, even competing fiscal and monetary policies.
• However, Islam demands a certain type of behaviour from
producers (and consumers).
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PRODUCER BEHAVIOUR IN ISLAM
• Muslims are bound by Islamic ethics and morals in
the market place.
• Conventional producers seek profit maximization,
while Islamic producer engages in profit sharing and
a reasonable profit
• Producers must not produce unlawful products or
activities.
• Producers must spend part of their wealth to the
less fortunate members in the Islamic society.
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ENTREPRENEUR AND PRODUCTION
IN ISLAM
• Muslim entrepreneurs bear the risk of profit or loss.
• As a partner, the entrepreneur can trade under two major
forms of business, being contractual partnership (sharikat al`aqd): mudharabah and musharakah. In each case, general
principles of factor pricing and income distribution will be
applied in the ex ante (before the event) determination of the
share of capital and entrepreneurship.
• Ibn Qudamah said, “it is not permissible to guarantee for any
partner a pre-specified number of dirhams. If one partner's
profit amount is specified in dirhams, or if a specified
increment over his profit-share is pre-specified, the
partnership is thus invalidated” (Al-Mughni).
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ISLAMIC PARTNERSHIPS
• The ex-ante determination of profit & loss sharing for
mudharabah and musharakah are based on factor
pricing of capital and entrepreneurship that is based on
justice.
• The income distribution for musharakah and
mudharabah are equitable, because each partner
receives a share in the profit on the basis of the
partner’s contribution to the production process.
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MUDHARABAH BUSINESS
• In this case of mudharabah, the owner of the capital
(rabb al-mal) and gives his investment capital (ras almal) to the entrepreneur (mudarib), to manage the
business, and each will have an agreed share of the
profit.
• In case there is a loss, the owner of the capital will
bear the loss and the mudarib will lose his time and
effort.
• The ex ante (before the event) determination of the
share capital in the case of mudharabah will be
determined by the interaction of the demand for (Dk)
and supply of capital (Sk).
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EX-ANTE DETERMINATION OF PROFITSHARES IN MUDHARABAH
• Prices (profit shares) of capital and
entrepreneurship in percentage
terms are measured along the left
and right vertical axes, and the
amount of capital along the
horizontal axis.
• Sk is upward sloping implying that
the quantity of capital supplied
increases as the capital provider’s
profit-share increases.
• Dk is downward sloping implying
that the quantity of capital
demanded increases as the capital
provider’s profit-share decreases.
• Sk and Dk intersect at T, determines
the profit-share ratio: e.g. 60:40
• The risk of losses are incurred by
the capital provider and the
entrepreneur’s service will go
unrewarded.
Source: Sadeq, 1990:54
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MUSHARAKAH BUSINESS
• Musharakah involves two or more partners combining
their capital in a business.
• The partners jointly manage and jointly bear the risk of
profit and loss in a pre-agreed proportion.
• The loss is apportioned according the ratio of capital
contributed by each partner, and the profit is distributed
according to a pre-agreed ratio by mutual consent.
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EX-ANTE DETERMINATION OF PROFITSHARES IN MUSHARAKAH
• Upper & lower horizontal axes
represent capital provided by A & B,
whilst left & right axes depict their
respective profit-shares.
• If Shafi’i or Maliki, partners should
share in profits according to their
respective contribution of capital,
given by Oa-R-Ob, assuming A
contributes 25% of the capital and
thus A receives 25% of the profit.
• If Hanafi or Hanbali, partners may
vary their profit share reflecting
entrepreneurial ability, e.g. either
Oa-N-Ob or Oa-M-Ob.
• The distribution of any losses are
based on the share of capital
contributed, because the share of
entrepreneurial services will go
unrewarded. For losses Oa-R-Ob
would thus apply.
Source: Sadeq, 1990:56
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GROWTH AND CAPITAL IN
AN ISLAMIC ECONOMY
• Clearly, the Islamic economic system encourages and facilitates the
mobilization of the factors of production necessary for economic
growth.
• Natural resources are made available in abundance for man to
explore and use them for the production of goods and services to
meet man’s needs including moral and social obligations.
• The optimal use of human resources and hard work is necessary to
produce goods and services in order to meet limited needs.
• But Islam does not undermine capital (like socialism) nor pay capital
nominal interest out of net revenues (like capitalism), but recognizes
the importance of capital in the production process, through a predetermined percentage of profits (or losses).
• Risk and rewards are shared by capital providers and entrepreneurs:
the provision of Islamic finance is by default entrepreneurial.
• The system of sharing profits (or losses) has the potential to
increase investment up to the level at which marginal profit is zero
(Sadeq, 1990:6-7)
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5. Efficiency of resource allocation
41
EFFICIENCY OF RESOURCE ALLOCATION &
THE MARGIN EFFICIENCY OF CAPITAL (MEC)
• “The marginal efficiency of capital is equal to that rate of
discount which would make the present value of the series of
annuities given by the returns expected from the capital asset
during its life just equal to its supply price.” (Keynes, 1936:135).
• The discount rate at which the PV of future cash flow equals
the initial investment: the break-even RoR of an investment.
• MEC is the RoR that makes the NPV of cash flows from an
investment = 0
• As the quantity of investment increases, the RoR decreases,
since the most profitable projects are undertaken first.
• Additional investment generates progressively lower RoRs.
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MEC = IRR
• A lower interest rate makes investment relatively more attractive.
• If the interest is 10% then only projects with a RoR > 10% will be
profitable.
Interest
• When the MEC = the
interest payment, an
entrepreneur will stop
investing.
R1
R2
MEC
I1
I2
Investment
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EFFICIENCY OF RESOURCE ALLOCATION IN
AN ISLAMIC ECONOMY
• As per the following table, investment can be carried out by the
entrepreneur to the fullest potential in an Islamic economy.
• For example, assuming the pre-determined profit-sharing ratio is 60:40
between the entrepreneur (mudarib) and capital provider (rabb al-mal).
• If capital is borrowed from a conventional bank at an interest rate of $10
per $1000 per project period, of say 3 months (short-term trading).
• An entrepreneur can invest up to $9000 since the marginal efficiency of
capital equals the interest payment: at this level of investment, the
additional $1000 of invested capital generates $10 in profit but he has to
pay $10 in interest. The borrowed capital costs a total of $90 in interest,
with profits after interest payment of $595 - $90 = $505
• If he invests $8000, the profit after interest is also $585 - $80 = $505,
therefore the lower investment is less risky.
• The Islamic entrepreneur will continue investing capital up to $13000
since he continues to receive positive profits, an may even invest
$14000 without further risk to himself even when the net gain is zero
(Sadeq, 1990:6-7)
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EFFICIENCY OF RESOURCE ALLOCATION
IN AN ISLAMIC ECONOMY
Source: Sadeq, 1990:22
45
EFFICIENCY OF RESOURCE ALLOCATION IN
AN ISLAMIC ECONOMY
• Investment and in turn employment is expected to be
higher in an Islamic economy.
• An Islamic economy is more efficient at allocating investible
resources than a conventional economy.
• Investment financed by debt at interest is less efficient that
equity finance (from savings) and profit sharing. Investment,
production, employment and economic growth (real GDP)
all increase.
• Keynes said that “interest holds back investment in
production” (1936, p.235), and interest “sets a limit to the
level of employment” due to the reduced marginal efficiency
of interest-based capital (1936, p.222).
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AGGREGATE EXPENDITURE MODEL
• Investment, production and in turn employment is expected to be
higher in an Islamic economy.
AE (C+I)
AS
AE1
AE
Y0
Y1
Y (Real GDP)
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IBN KHALDUN AGGREGATE
EXPENDITURE MODEL
• “Income and expenditure balance each other in every city”
(Ibn Khaldun, 1958, 2:275)
AD = AE = C+I
AS = AD = AMD = Y
Y = GDP = P x Q
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