Muhammad Arif
Member Visiting Faculty Sheikh Zayed
Sultan Institute University of Karachi &
BIZTEK/KASBIT/MAJU Karachi
Islamic Economics 1
According to the course and syllabus prescribed in
all universities in Pakistan
Islamic Economics
1
Forwarding note
The book has been written and compiled in order to meet students’
demands who are short of material on Islamic economics. To keep
them aware of current economic thoughts, the first part of the book
covers basics of conventional economics and than from onward we
have moved towards explaining Islamic economic thoughts. The
purpose of such modality is to keep them abreast with challenges
that one has to confront in implementing Islamic economic
thoughts in current economic scenario.
2
Islamic Economics
Contents
Chapter Subject
Page
No
3
12
1
2
Defining Conventional Economics
Dynamics of Demand and Supply
3
37
4
Dynamics of Substitution, Budgeting
and Functions of Production
Market Behavior/Game Theory
5
Income and Wealth
70
6
Macro-economics/Development
Economics/International Economics
Defining Islamic Economics
88
7
8
56
114
121
11
12
13
Evolution of Islamic Economic
Thoughts
Application of Islamic Economics on
Discipline
of
Micro,
Macro,
Development and International
Economics
Fiscal
and
Monetary
Policy
Framework in Islamic Economics
Defining Riba and Islamic Banking
Islamic Modes of Financing
Exercises
14
16
Bibliography
Profile about writer
193
194
9
10
133
145
161
169
190
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Chapter 1
Defining conventional economics
Economics is the social science that studies the production,
distribution, and consumption of goods and services. The
term economics comes from the Ancient Greek οἰκονομία
(oikonomia,
"management
of
a
household,
administration") from οἶκος (oikos, "house") + νόμος
(Nomo's, "custom" or "law"), hence "rules of the
house(hold)".
A definition that captures much of modern economics is
that of Lionel Robbins in a 1932 essay: "the science which
studies human behavior as a relationship between ends
and scarce means which have alternative uses."[
Common distinctions are drawn between various
dimensions of economics: between positive economics
(describing "what is") and normative economics
(advocating "what ought to be") or between economic
theory and applied economics or between mainstream
economics (more "orthodox" dealing with the "rationalityindividualism-equilibrium
nexus")
and
heterodox
economics (more "radical" dealing with the "institutionshistory-social structure nexus"[
Primary textbook distinction is between microeconomics
("small" economics), which examines the economic
behavior of agents (including individuals and firms) and
macroeconomics ("big" economics), addressing issues of
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unemployment, inflation, monetary and fiscal policy for an
entire economy.
The city states of Sumer developed a trade and market
economy based originally on the commodity money of the
Shekel which was a certain weight measure of barley,
while the Babylonians and their city state neighbors later
developed the earliest system of economics using a metric
of various commodities, that was fixed in a legal code. The
early law codes from Sumer could be considered the first
(written) economic formula, and had many attributes still
in use in the current price system today... such as codified
amounts of money for business deals (interest rates), fines
in money for 'wrong doing', inheritance rules, laws
concerning how private property is to be taxed or divided,
etc.
Economic thought dates from earlier Mesopotamian,
Greek, Roman, Indian, Chinese, Persian and Arab
civilizations. Notable writers include Aristotle, Chanakya
(also known as Kautilya), Qin Shi Huang, Thomas Aquinas
and Ibn Khaldun through to the 14th century. Joseph
Schumpeter initially considered the late scholastics of the
14th to 17th centuries as "coming nearer than any other
group to being the 'founders' of scientific economics" as to
monetary, interest, and value theory within a natural-law
perspective. After discovering Ibn Khaldun's Muqaddimah,
however, Schumpeter later viewed Ibn Khaldun as being
the closest forerunner of modern economics, as many of
his economic theories were not known in Europe until
relatively modern times.
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Adam Smith's The Wealth of Nations in 1776 has been
described as "the effective birth of economics as a
separate discipline. The book identified land, labor, and
capital as the three factors of production and the major
contributors to a nation's wealth.
In Smith's view, the ideal economy is a self-regulating
market system that automatically satisfies the economic
needs of the populace. He described the market
mechanism as an "invisible hand" that leads all individuals,
in pursuit of their own self-interests, to produce the
greatest benefit for society as a whole.
In his famous invisible-hand analogy, Smith argued for the
seemingly paradoxical notion that competitive markets
tended to advance broader social interests, although
driven by narrower self-interest. The general approach
that Smith helped initiate was called political economy and
later classical economics. It included such notables as
Thomas Malthus, David Ricardo, and John Stuart Mill
writing from about 1770 to 1870.
While Adam Smith emphasized the production of income,
David Ricardo focused on the distribution of income
among landowners, workers, and capitalists. Ricardo saw
an inherent conflict between landowners on the one hand
and labor and capital on the other. He posited that the
growth of population and capital, pressing against a fixed
supply of land, pushes up rents and holds down wages and
profits.
Thomas Robert Malthus used the idea of diminishing
returns to explain low living standards. Population, he
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argued, tended to increase geometrically, outstripping the
production of food, which increased arithmetically. The
force of a rapidly growing population against a limited
amount of land meant diminishing returns to labor. The
result, he claimed, was chronically low wages, which
prevented the standard of living for most of the
population from rising above the subsistence level.
Malthus also questioned the automatic tendency of a
market economy to produce full employment. He blamed
unemployment upon the economy's tendency to limit its
spending by saving too much, a theme that lay forgotten
until John Maynard Keynes revived it in the 1930s
Coming at the end of the Classical tradition, John Stuart
Mill parted company with the earlier classical economists
on the inevitability of the distribution of income produced
by the market system. Mill pointed to a distinct difference
between the market's two roles: allocation of resources
and distribution of income. The market might be efficient
in allocating resources but not in distributing income, he
wrote, making it necessary for society to intervene.
Value theory was important in classical theory. Smith
wrote that the "real price of every thing ... is the toil and
trouble of acquiring it" as influenced by its scarcity. Smith
maintained that, with rent and profit, other costs besides
wages also enter the price of a commodity.
Marxist (later, Marxian) economics also descends from
classical economics. It derives from the work of Karl Marx.
The first volume of Marx's major work, Das Kapital, was
published in German in 1867. In it, Marx focused on the
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labor theory of value and what he considered to be the
exploitation of labor by capital. The labor theory of value
held that the value of a thing was determined by the labor
that went into its production. This contrasts with the
modern understanding that the value of a thing is
determined by what one is willing to give up to obtain the
thing.
A body of theory later termed 'neoclassical economics' or
'marginalism' formed from about 1870 to 1910. The term
'economics' was popularized by such neoclassical
economists as Alfred Marshall as a concise synonym for
'economic science' and a substitute for the earlier, broader
term 'political economy'. This corresponded to the
influence on the subject of mathematical methods used in
the natural sciences.
Neoclassical economics systematized supply and demand
as joint determinants of price and quantity in market
equilibrium, affecting both the allocation of output and
the distribution of income. It dispensed with the labor
theory of value inherited from classical economics in favor
of a marginal utility theory of value on the demand side
and a more general theory of costs on the supply side.
In microeconomics, neoclassical economics represents
incentives and costs as playing a pervasive role in shaping
decision making. An immediate example of this is the
consumer theory of individual demand, which isolates how
prices (as costs) and income affect quantity demanded. In
macroeconomics it is reflected in an early and lasting
neoclassical synthesis with Keynesian macroeconomics.
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Keynesian economics derives from John Maynard Keynes,
in particular his book The General Theory of Employment,
Interest and Money (1936), which ushered in
contemporary macroeconomics as a distinct field. The
book focused on determinants of national income in the
short run when prices are relatively inflexible. Keynes
attempted to explain in broad theoretical detail why high
labor-market unemployment might not be self-correcting
due to low "effective demand" and why even price
flexibility and monetary policy might be unavailing. Such
terms as "revolutionary" have been applied to the book in
its impact on economic analysis.
The Chicago School of economics is best known for its free
market advocacy and monetarist ideas. According to
Milton Friedman and monetarists, market economies are
inherently stable if left to themselves and depressions
result only from government intervention. Friedman, for
example, argued that the Great Depression was result of a
contraction of the money supply, controlled by the Federal
Reserve, and not by the lack of investment as Keynes had
argued. Ben Bernanke, current Chairman of the Federal
Reserve, is among the economists today generally
accepting Friedman's analysis of the causes of the Great
Depression.
Microeconomics looks at interactions through individual
markets, given scarcity and government regulation. A
given market might be for a product, say fresh corn, or the
services of a factor of production, say bricklaying. The
theory considers aggregates of quantity demanded by
buyers and quantity supplied by sellers at each possible
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price per unit. It weaves these together to describe how
the market may reach equilibrium as to price and quantity
or respond to market changes over time.
This is broadly termed supply and demand analysis.
Market structures, such as perfect competition and
monopoly, are examined as to implications for behavior
and economic efficiency. Analysis of change in a single
market often proceeds from the simplifying assumption
that behavioral relations in other markets remain
unchanged, that is, partial-equilibrium analysis. Generalequilibrium theory allows for changes in different markets
and aggregates across all markets, including their
movements and interactions toward equilibrium
Macroeconomics examines the economy as a whole to
explain broad aggregates and their interactions "top
down," that is, using a simplified form of generalequilibrium theory. Such aggregates include national
income and output, the unemployment rate, and price
inflation and sub aggregates like total consumption and
investment spending and their components. It also studies
effects of monetary policy and fiscal policy.
Since at least the 1960s, macroeconomics has been
characterized by further integration as to micro-based
modeling of sectors, including rationality of players,
efficient use of market information, and imperfect
competition. This has addressed a long-standing concern
about inconsistent developments of the same subject.
Macroeconomic analysis also considers factors affecting
the long-term level and growth of national income. Such
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factors include capital accumulation, technological change
and labor force growth.
International trade studies determinants of goods-andservices flows across international boundaries. It also
concerns the size and distribution of gains from trade.
Policy applications include estimating the effects of
changing tariff rates and trade quotas. International
finance is a macroeconomic field which examines the flow
of capital across international borders, and the effects of
these movements on exchange rates. Increased trade in
goods services and capital between countries is a major
effect of contemporary globalization.
The distinct field of development economics examines
economic aspects of the development process in relatively
low-income countries focusing on structural change,
poverty, and economic growth. Approaches in
development economics frequently incorporate social and
political factors.
Economic systems are the branch of economics that
studies the methods and institutions by which societies
determine the ownership, direction, and allocation of
economic resources. An economic system of a society is
the unit of analysis.
Among contemporary systems at different ends of the
organizational spectrum are socialist systems and capitalist
systems, in which most production occurs in respectively
state-run and private enterprises. In between are mixed
economies. A common element is the interaction of
economic and political influences, broadly described as
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political economy. Comparative economic systems study
the relative performance and behavior of different
economies or systems.
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Chapter 2
Dynamics of Demand and Supply
The power of supply and demand was understood to some
extent by several early Muslim economists, such as Ibn
Taymiyyah who illustrates:
"If desire for goods increases while its availability decreases,
its price rises. On the other hand, if availability of the good
increases and the desire for it decreases, the price comes
down.”
The phrase "supply and demand" was first used by James
Denham-Stuart in his Inquiry into the Principles of Political
Economy, published in 1767. Adam Smith used the phrase in
his 1776 book The Wealth of Nations, and David Ricardo titled
one chapter of his 1817 work Principles of Political Economy
and Taxation "On the Influence of Demand and Supply on
Price".
In The Wealth of Nations, Smith generally assumed that the
supply price was fixed but that its "merit" (value) would
decrease as its "scarcity" increased, in effect what was later
called the law of demand. Ricardo, in Principles of Political
Economy and Taxation, more rigorously laid down the idea of
the assumptions that were used to build his ideas of supply
and demand. Antoine Augustin Cournot first developed a
mathematical model of supply and demand in his 1838
Researches on the Mathematical Principles of the Theory of
Wealth.
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During the late 19th century the marginalist school of thought
emerged. This field mainly was started by Stanley Jevons, Carl
Menger, and Léon Walras. The key idea was that the price was
set by the most expensive price, that is, the price at the
margin. This was a substantial change from Adam Smith's
thoughts on determining the supply price.
In his 1870 essay "On the Graphical Representation of Supply
and Demand", Fleeming Jenkin drew for the first time the
popular graphic of supply and demand which, through
Marshall, eventually would turn into the most famous graphic
in economics.
The model was further developed and popularized by Alfred
Marshall in the 1890 textbook Principles of Economics. Along
with Léon Walras, Marshall looked at the equilibrium point
where the two curves crossed. They also began looking at the
effect of markets on each other.
The analysis of supply and demand shows how a market
mechanism solves the three problems of what, how, and for
whom. A market blends together demands and supplies.
Demand comes from consumers who are spreading their
money among available goods and services, while businesses
supply the goods and services with the goal of maximizing
their profits.
A demand schedule shows the relationship between the
quantity demanded and the price of a commodity, other
things held constant. Such a demand schedule, depicted
graphically by a demand curve, holds constant other things
like family incomes, tastes, and the prices of other goods.
Almost all commodities obey the law of downward-sloping
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demand, which holds that quantity demanded falls as a good's
price rises. This law is represented by a downward-sloping
demand curve.
Many influences lie behind the demand schedule for the
market as a whole: average family incomes, population, the
prices of related goods, tastes, and special influences. When
these influences change, the demand curve will shift.
The supply schedule (or supply curve) gives the relationship
between the quantity of a good that producers desire to sell-other things constant--and that good's price. Quantity
supplied generally responds positively to price, so the supply
curve is upward-sloping.
Elements other than the good's price affect its supply. The
most important influence is the commodity's production cost,
determined by the state of technology and by input prices.
Other elements in supply include the prices of related goods,
government policies, and special influences.
The equilibrium of supply and demand in a competitive
market occurs when the forces of supply and demand are in
balance. The equilibrium price is the price at which the
quantity demanded just equals the quantity supplied.
Graphically, we find the equilibrium at the intersection of the
supply and demand curves. At a price above the equilibrium,
producers want to supply more than consumers want to buy,
which results in a surplus of goods and exerts downward
pressure on price. Similarly, too low a price generates a
shortage, and buyers will therefore tend to bid price upward
to the equilibrium.
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Shifts in the supply and demand curves change the
equilibrium price and quantity. An increase in demand, which
shifts the demand curve to the right, will increase both
equilibrium price and quantity. An increase in supply, which
shifts the supply curve to the right, will decrease price and
increase quantity demanded.
To use supply-and-demand analysis correctly, we must (a)
distinguish a change in demand or supply (which produces a
shift of a curve) from a change in the quantity demanded or
supplied (which represents a movement along a curve); (b)
hold other things constant, which requires distinguishing the
impact of a change in a commodity's price from the impact of
changes in other influences; and (c) look always for the
supply-and-demand equilibrium, which comes at the point
where forces acting on price and quantity are in balance.
Competitively determined prices ration the limited supply of
goods among those who demand them.
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Elasticity is a central concept in the theory of supply and
demand. In this context, elasticity refers to how supply and
demand respond to various factors, including price as well as
other stochastic principles. One way to define elasticity is the
percentage change in one variable divided by the percentage
change in another variable (known as arc elasticity, which
calculates the elasticity over a range of values, in contrast with
point elasticity, which uses differential calculus to determine
the elasticity at a specific point). It is a measure of relative
changes.
Often, it is useful to know how the quantity demanded or
supplied will change when the price changes. This is known as
the price elasticity of demand and the price elasticity of
supply. If a monopolist decides to increase the price of their
product, how will this affect their sales revenue? Will the
increased unit price offset the likely decrease in sales volume?
If a government imposes a tax on a good, thereby increasing
the effective price, how will this affect the quantity
demanded?
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Elasticity corresponds to the slope of the line and is often
expressed as a percentage. In other words, the units of
measure (such as gallons vs. quarts, say for the response of
quantity demanded of milk to a change in price) do not
matter, only the slope. Since supply and demand can be
curves as well as simple lines the slope, and hence the
elasticity, can be different at different points on the line.
Elasticity is calculated as the percentage change in quantity
over the associated percentage change in price. For example,
if the price moves from PKR1.00 to PKR1.05, and the quantity
supplied goes from 100 pens to 102 pens, the slope is 2/0.05
or 40 pens per PKR. Since the elasticity depends on the
percentages, the quantity of pens increased by 2%, and the
price increased by 5%, so the price elasticity of supply is 2/5 or
0.4.
It is defined as the responsiveness of the quantity demanded
of a good or service to a change in its price.
In other words, it is percentage change of quantity demanded
by the percentage change in price of the same commodity. In
economics and business studies, the price elasticity of demand
is a measure of the sensitivity of quantity demanded to
changes in price. It is measured as elasticity, that it measures
the relationship as the ratio of percentage changes between
quantity demanded of a good and changes in its price. Price
elasticity is almost always negative, although analysts tend to
ignore the sign. Only goods which do not conform the law of
demand, such as Veblen (In economics, Veblen goods are a
group of commodities for which peoples' preference for
buying them increases as a direct function of their price, as
greater price confers greater status, instead of decreasing
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according to the law of demand. Some types of high-status
goods, such as high-end wines, designer handbags and luxury
cars) and Giffen goods (In economics and consumer theory, a
Giffen good is one which people consume more of as price
rises, violating the law of demand like staple or inferior food)
have a positive PED.
Ed = % change in quantinity demanded / % change in price =
(ΔQd/Qd)/(ΔPd/Pd)
In economics, Es is defined as a numerical measure of the
responsiveness of the quantity supplied of product (A) to a
change in price of product (A) alone. It is the measure of the
way quantity supplied reacts to a change in price.
Es = % change in quantity supplied/ % change in price
For example, if, in response to a 10% rise in the price of a
good, the quantity supplied increases by 20%, the price
elasticity of supply would be 20%/10% = 2.
When there is a relatively inelastic supply for the good the
coefficient is low; when supply is highly elastic, the coefficient
is great. Supply is normally more elastic in the long run than in
the short run for produced goods, since it is generally
assumed that in the long run all factors of production can be
utilized to increase supply, whereas in the short run only labor
can be increased. Of course goods that have no labor
component and are not produced cannot be expanded. Such
goods are said to be "fixed" in supply and do not respond to
price changes. If the coefficient is exactly one, the good is said
to be unitary elastic.
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In economics, it is a transformation curve that is a graph that
shows the different rates of production of two goods that an
individual or group can efficiently produce with limited
productive resources. The PPF shows the maximum
obtainable amount of one commodity for any given amount of
another commodity or composite of all other commodities,
given the society's technology and the amount of factors of
production available.
A PPF simultaneously shows all possible combinations of two
goods that can be produced ceteris paribus; commonly it takes
the form of the curve on the right. Invariably, in order for an
economy to increase the quantity of one good (here, butter)
produced, production of the other good (here, guns) must be
sacrificed. PPFs are most commonly used to predict how much
of the latter must be sacrificed for a given increase in
production of the former
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In economics, the marginal utility of a good or service is the
utility gained (or lost) from an increase (or decrease) in the
amount available of that good or service. Marginal utility is
the utility associated with the marginal use—the specific use
to which an agent would put a given increase in that good or
service, or of the specific use that would be abandoned in
response to a given decrease—which, if the economic factor is
economically rational, would (in the case of an increase) be
the most urgent use of the good or service for which it could
be used (or, in the case of a decrease, the least urgent for
which it is currently used).Under the mainstream
assumptions, the marginal utility of a good or service is the
posited quantified change in utility obtained by increasing or
decreasing use of that good or service.
Marginality: - They are the constraints that are conceptualized
as a border or margin. The location of the margin for any
individual corresponds to his or her endowment, broadly
conceived to include opportunities.
A value that holds true given particular constraints is a
marginal value. A change that would be effected as or by a
specific loosening or tightening of those constraints is a
marginal change, as large as the smallest relevant division of
that good or service.
Different concepts of utility were and have been employed
during and subsequent to the development of theory
employing notions of marginal utility. It has been common
among economists to describe utility as corresponding to a
measure, that is to say, as being quantifiable. This has
significantly affected the development and reception of
theories of marginal utility. Concepts of utility that entail
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quantification allow familiar arithmetic operations, and
further assumptions of continuity and differentiability greatly
increase tractability. However, concepts without even weak
quantification are able to consider rational preferences that
would otherwise be excluded.
An individual will typically be able to partially order the
potential uses of a good or service. For example, a ration of
water might be used to sustain oneself, a dog, or a rose bush.
Say that a given person gives her own sustenance highest
priority, that of the dog next highest priority, and lowest
priority to saving the roses. In that case, if the individual has
two rations of water, then the marginal utility of either of
those rations is that of sustaining the dog. The marginal utility
of a third unit would be that of watering the roses.
The diminishing of marginal utility should not necessarily be
taken to be itself an arithmetic subtraction. It may be no more
than a purely ordinal change.
The notion that marginal utilities are diminishing across the
ranges relevant to decision-making is called “the law of
diminishing marginal utility” (and also known as a “Gossen's
First Law”). However, it will not always hold. The case of the
person, dog, and roses is one in which potential uses operate
independently—there is no complementarities across the
three uses. Sometimes an amount added brings things past a
desired tipping point, or an amount subtracted causes them to
fall short. In such cases, the marginal utility and diseconomies of
scale refer to an economic property of production that affects cost
if quantities of all input factors are increased by some amount. If
costs increase proportionately, there are no economies of scale; if
costs increase by a greater amount, there are diseconomies of scale;
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if costs increase by a lesser amount; there are positive economies of
scale. When combined, economies of scale and diseconomies of
scale lead to ideal firm size theory, which states that per-unit costs
decrease until they reach a certain minimum, then increase as the
firm size increases further.
Economies of scale refers to the decreased per unit cost as output
increases. More clearly, the initial investment of capital is diffused
(spread) over an increasing number of units of output, and
therefore, the marginal cost of producing a good or service
decreases as production increases (note that this is only in an
industry that is experiencing economies of scale)
Economies of scale tend to occur in industries with high capital costs
in which those costs can be distributed across a large number of
units of production (both in absolute terms, and, especially, relative
to the size of the market). A common example is a factory. An
investment in machinery is made, and one worker, or unit of
production, begins to work on the machine and produces a certain
number of goods. If another worker is added to the machine he or
she is able to produce an additional amount of goods without
adding significantly to the factory's cost of operation. The amount
of goods produced grows significantly faster than the plant's cost of
operation. Hence, the cost of producing an additional good is less
than the good before it, and an economy of scale emerges.
Economies of scale are also derived partially from learning by doing.
Utility of a good or service might actually be increasing. For
example:
•
bed sheets, which up to some number may only
provide warmth, but after that point may allow one to
effect an escape by being tied together into a rope;
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•
tickets, for travel or theatre, where a second ticket might
allow one to take a date on an otherwise uninteresting
outing;
•
Dosages of antibiotics, where having too few pills would
leave bacteria with greater resistance, but a full supply
could effect a cure.
•
The fact that a tipping point may be reached does not imply
that marginal utility will continue to increase indefinitely
thereafter. For example, beyond some point, further doses
of antibiotics would kill no pathogens at all.
Marginalism explains choice with the hypothesis that people decide
whether to effect any given change based on the marginal utility of
that change, with rival alternatives being chosen based upon which
has the greatest marginal utility.
If an individual has a stock or flow of a good or service whose
marginal utility is less than would be that of some other good or
service for which he or she could trade, then it is in his or her
interest to effect that trade. Of course, as one thing is traded-away
and another is acquired, the respective marginal gains or losses
from further trades are now changed. On the assumption that the
marginal utility of one is diminishing, and the other is not increasing,
all else being equal, an individual will demand an increasing ratio of
that which is acquired to that which is sacrificed. (One important
way in which all else might not be equal is when the use of the one
good or service complements that of the other. In such cases,
exchange ratios might be constant. If any trader can better his or
her own marginal position by offering a trade more favorable to
complementary traders, then he or she will do so.
In an economy with money, the marginal utility of a quantity is
simply that of the best good or service that it could purchase.
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Hence, the “law” of diminishing marginal utility provides an
explanation for diminishing marginal rates of substitution and thus
for the “laws” of supply and demand, as well as essential aspects of
models of “imperfect” competition.
The “law” of diminishing marginal utility is said to explain the
“paradox of water and diamonds”, most commonly associated with
Adam Smith (though recognized by earlier thinkers).Human beings
cannot even survive without water, whereas diamonds were in
Smith's day mere ornamentation or engraving bits. Yet water had a
very low price, and diamonds a very high price, by any normal
measure. Marginalists explained that it is the marginal usefulness of
any given quantity that determines its price, rather than the
usefulness of a class or of a totality. For most people, water was
sufficiently abundant that the loss or gain of a gallon would
withdraw or add only some very minor use if any; whereas
diamonds were in much more restricted supply, so that the lost or
gained use would be much greater.
That is not to say that the price of any good or service is simply a
function of the marginal utility that it has for any one individual nor
for some ostensibly typical individual. Rather, individuals are willing
to trade based upon the respective marginal utilities of the goods
that they have or desire (with these marginal utilities being distinct
for each potential trader), and prices thus develop constrained by
these marginal utilities.
The “law” do not tell us such things as why diamonds are naturally
less abundant on the earth than is water, but helps us to
understand how this affects the value imputed to a given diamond
and the price of diamonds in a mark
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Value of a good or service in economics has puzzled economists
since the beginning of the discipline. First, economists tried to
estimate the value of a good to an individual alone, and extend that
definition to goods which can be exchanged. From this analysis
came the concepts value in use and value in exchange.
Wealth maximization predicts that a person will choose to obtain
the good or service in the place where it is cheapest, where the
amount given up is the least.
Value is linked to price through the mechanism of exchange. When
an economist observes an exchange, two important value functions
are revealed: those of the buyer and seller. Just as the buyer reveals
what he is willing to pay for a certain amount of a good, so too does
the seller reveal what it costs him to give up the good.
Additional information about value is obtained by the rate at which
transactions occur, telling observers the extent to which the
purchase of the good has value over time.
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Said another way, value is how much a desired object or condition is
worth relative to other objects or conditions. Economic values are
expressed as "how much" of one desirable condition or commodity
will, or would be given up in exchange for some other desired
condition or commodity. Among the competing schools of economic
theory there are differing metrics for value assessment and the
metrics are the subject of a "Theory of Value." Value theories are a
large part of the differences and disagreements between the
various schools of economics.
In neoclassical economics, the value of an object or service is often
seen as nothing but the price it would bring in an open and
competitive market. This is determined primarily by the demand for
the object relative to supply. Many neoclassical economic theories
equate the value of a commodity with its price, whether the market
is competitive or not. As such, everything is seen as a commodity
and if there is no market to set a price then there is no economic
value.
In classical economics, the value of an object or condition is the
amount of discomfort/labor saved through the consumption or use
of an object or condition (Labor Theory of Value). Though exchange
value is recognized, economic value is not dependent on the
existence of a market and price and value are not seen as equal.
In this tradition, to Steve Keen "value" refers to "the innate worth of
a commodity, which determines the normal ('equilibrium') ratio at
which two commodities exchange."To Keen and the tradition of
David Ricardo, this corresponds to the classical concept of long-run
cost-determined prices, what Adam Smith called "natural prices"
and Karl Marx called "prices of production." It is part of a cost-ofproduction theory of value and price. Ricardo, but not Keen, used a
"labor theory of price" in which a commodity's "innate worth" was
the amount of labor needed to produce it.
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In another classical tradition, Marx distinguished between the
"value in use" (use-value, what a commodity provides to its buyer),
"value" (the socially-necessary labor time it embodies), and
"exchange value" (how much labor-time the sale of the commodity
can claim, Smith's "labor commanded" value). By most
interpretations of his labor theory of value, Marx, like Ricardo,
developed a "labor theory of price" where the point of analyzing
value was to allow the calculation of relative prices. Others see
values as part of his sociopolitical interpretation and critique of
capitalism and other societies, and deny that it was intended to
serve as a category of economics. According to a third
interpretation, Marx aimed for a theory of the dynamics of price
formation, but did not complete it.
In 1860 John Ruskin published a critique of the economic concept of
value from a moral point of view. He entitled the volume Unto This
Last, and his central point was this: "It is impossible to conclude, of
any given mass of acquired wealth, merely by the fact of its
existence, whether it signifies good or evil to the nation in the midst
of which it exists. Its real value depends on the moral sign attached
to it, just as strictly as that of a mathematical quantity depends on
the algebraic sign attached to it. Any given accumulation of
commercial wealth may be indicative, on the one hand, of faithful
industries, progressive energies, and productive ingenuities: or, on
the other, it may be indicative of mortal luxury, merciless tyranny,
ruinous chicanery." Gandhi was greatly inspired by Ruskin's book
and published a paraphrase of it in 1908.
Economists such as Ludwig von Mises asserted that "value,"
meaning exchange value, was always the result of subjective value
judgments. There was no price of objects or things that could be
determined without taking these judgments into account, as
manifested by markets. Thus, it was false to say that the economic
value of a good was equal to what it cost to produce or to its
current replacement cost.
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Value in the most basic sense can be referred to as "Real Value" or
"Actual Value." This is the measure of worth that is based purely on
the utility derived from the consumption of a product or service.
Utility derived value allows products or services to be measured on
outcome instead of demand or supply theories that have the
inherent ability to be manipulated. Illustration: The real value of a
book sold to a student who pays PKR 50.00 at the cash register for
the text and who earns no additional income from reading the book
is essentially zero. However; the real value of the same text
purchased in a thrift shop at a price of PKR 0.25 and provides the
reader with an insight that allows him or her to earn PKR 100,
000.00 or additional income of PKR 100, 000.00 or the extended
lifetime value earned by the consumer. This is value calculated by
actual measurements of ROI instead of production input and or
demand vs. supply. No single unit has a fixed value. Value is
intrinsically related to the worth derived by the consumer. [Burke
(2005)].
Here we look at the importance of willingness to pay for different
goods and services. When there is a difference between the price
that you actually pay in the market and the price or value that you
place on the product, then the concept of consumer surplus becomes
a useful one to look at.
Consumer surplus is a measure of the welfare that people gain from
the consumption of goods and services, or a measure of the
benefits they derive from the exchange of goods.
Consumer surplus is the difference between the total amount that
consumers are willing and able to pay for a good or service
(indicated by the demand curve) and the total amount that they
actually do pay (i.e. the market price for the product). The level of
consumer surplus is shown by the area under the demand curve and
above the ruling market price as illustrated in the diagram in the
next slide:
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The Law of Equi-Marginal Utility is an extension to the law of
diminishing marginal utility. The principle of equiv.-marginal utility
explains the behavior of a consumer in distributing his limited
income among various goods and services. This law states that how
a consumer allocates his money income between various goods so
as to obtain maximum satisfaction.
The principle of equiv-marginal utility is based on the following
assumptions:
(a) The wants of a consumer remain unchanged.
(b) The prices of all goods are given and known to a consumer.
(c) He is one of the many buyers in the sense that he is powerless to
alter the market price.
(d) He can spend his income in small amounts.
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(e) He acts rationally in the sense that he wants maximum
satisfaction
(f) Utility is measured cardinally. This means that utility, or use of a
good, can be expressed in terms of "units" or "utils". This utility is
not only comparable but also quantifiable.
Maximum satisfaction out of the expenditure of a given sum can be
obtained if the utility derived from the last unit of money spent on
each object of expenditure is, more or less the same.
Illustration:Suppose a man goes to the market with Rs.400 in his pocket, which
he wants to spend on oranges, caps and milk, and further. Suppose
that the utility he expects to derive from each unit of Rs.20 spent on
these commodities is as follows.
Rs25/unit
Utility derived from the
Rs.25 spent on
Oranges
Caps
Milk
St
10
13
11
nd
8
12
9
rd
7
10
6
5
4
8
6
5
4
th
3
4
2
th
2
3
1
1
2
3
4rth
5
6
7
th
The purchaser will spend the first 25 on the object, which will give
him the greatest satisfaction. In this case such an article is cap; the
utility of its first unit is 13, which is maximum.
Guided by the same motive, he will spend the second Rs. 25 on
caps. He will spend the third Rs. 25 on milk and the fourth-on
oranges. In this way he will go spending money. The following table
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indicates the order in which he will spend the Rs.400 he has got
with him.
25
Object of expenditure
Cap
Utility derived
13
nd
Cap
12
rd
Milk
11
Orange
Cap
10
10
th
Milk
9
th
Cap
8
th
Orange
7
th
1
2
St
3
4rth
5
6
7
8
9
th
10
11
12
13
14
Cap
6
th
Milk
6
th
Orange
5
th
Milk
5
th
Orange
4
th
Cap
4
th
Milk
4
orange
3
15
16th
Total utility derived from Rs. 400 out off 117
The above table shows that he will spend Rs. 25 each 5 on oranges,
6 on caps, and 5 on milk, and will in total derive 117 units of utility.
This is the maximum satisfaction that he can obtain out of his
expenditure. If he does not follow this scheme of expenditure, he
will not be able to derive maximum total utility.
Therefore, if we want to derive maximum satisfaction out of our
expenditure, we should spend our money in such a way as to derive,
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more or less, the same satisfaction from the last unit of money
spends on each head. This is the law of Equi-marginal utility.
In microeconomic theory, an indifference curve is a graph showing
different bundles of goods, each measured as to quantity, between
which a consumer is indifferent. That is, at each point on the curve,
the consumer has no preference for one bundle over another. In
other words, they are all equally preferred. One can equivalently
refer to each point on the indifference curve as rendering the same
level of utility (satisfaction) for the consumer. Utility is then a device
to represent preferences rather than something from which
preferences come. The main use of indifference curves is in the
representation of potentially observable demand patterns for
individual consumers over commodity bundles.
The theory of indifference curves was developed by Francis Ysidro
Edgeworth, Vilfredo Pareto and others in the first part of the 20th
century. The theory can be derived from ordinal utility theory,
which posits that individuals can always rank any consumption
bundles by order of preference
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In regard to above, production function specifies the maximum
output that can be produced with a given quantity of inputs. It is
defined for a given state of engineering and the technical
knowledge.
Whereas total product designates the total amount of output
produced, in physical units such as bushels of wheat or number of
telephone calls produced.
Once we know the total product, it is easy to derive marginal
product which is the extra product or output added by 1 extra unit
of that output while other outputs are held constant.
The final concept is the average product which equals total output
divided by total units of inputs
In economics, diminishing returns (also called diminishing marginal
returns) refers to how the marginal production of a factor of
production starts to progressively decrease as the factor is
increased, in contrast to the increase that would otherwise be
normally expected. According to this relationship, in a production
system with fixed and variable inputs (say factory size and labor),
there will be a point beyond which each additional unit of the
variable input (i.e., man-hours) yields smaller and smaller increases
in outputs, also reducing each worker's mean productivity.
Conversely, producing one more unit of output will cost increasingly
more (owing to the major amount of variable inputs being used, to
little effect).
This concept is also known as the law of diminishing marginal
returns or the law of increasing relative cost.
Suppose that one kilogram of seed applied to a plot of land of a
fixed size produces one ton of crop. You might expect that an
additional kilogram of seed would produce an additional ton of
output. However, if there are diminishing marginal returns, that
additional kilogram will produce less than one additional ton of crop
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(ceteris paribus). For example, the second kilogram of seed may
only produce a half ton of extra output. Diminishing marginal
returns also implies that a third kilogram of seed will produce an
additional crop that is even less than a half ton of additional output,
say, one quarter of a ton.
In economics, the term "marginal" is used to mean on the edge of
productivity in a production system. The difference in the
investment of seed in these three scenarios is one kilogram —
"marginal investment in seed is one kilogram." And the difference in
output, the crops, is one ton for the first kilogram of seeds, a half
ton for the second kilogram, and one quarter of a ton for the third
kilogram. Thus, the marginal physical product (MPP) of the seed will
fall as the total amount of seed planted rises. In this example, the
marginal product (or return) equals the extra amount of crop
produced divided by the extra amount of seeds planted.
A consequence of diminishing marginal returns is that as total
investment increases, the total return on investment as a
proportion of the total investment (the average product or return)
decreases. The return from investing the first kilogram is 1 t/kg. The
total return when 2 kg of seed are invested is 1.5/2 = 0.75 t/kg,
while the total return when 3 kg are invested is 1.75/3 = 0.58 t/kg.
Another example is a factory that has a fixed stock of capital, or
tools and machines, and a variable supply of labor. As the firm
increases the number of workers, the total output of the firm grows
but at an ever-decreasing rate. This is because after a certain point,
the factory becomes overcrowded and workers begin to form lines
to use the machines. The long-run solution to this problem is to
increase the stock of capital, that is, to buy more machines and to
build more factories.
In economics, returns to scale and economies of scale are related
terms that describe what happens as the scale of production
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increases. They are different terms and should not be used
interchangeably.
Returns to scale
In production, returns to scale refer to changes in output
subsequent to a proportional change in all inputs (where all inputs
increase by a constant factor). If output increases by that same
proportional change then there are constant returns to scale (CRTS).
If output increases by less than that proportional change, there are
decreasing returns to scale (DRS). If output increases by more than
that proportion, there are increasing returns to scale (IRS)
Short example: where all inputs increase by a factor of 2, new
values for output should be:
•
Twice the previous output given = a constant return to scale
(CRTS)
•
Less than twice the previous output given = a decreased
return to scale (DRS)
•
More than twice the previous output given = an increased
return to scale (IRS)
•
Assuming that the factor costs are constant, a firm
experiencing CRTS will have constant average costs, a firm
experiencing DRS will have increasing average costs and a
firm experiencing IRS will have decreasing average costs.
And diseconomies of scale refer to an economic property of
production that affects cost if quantities of all input factors are
increased by some amount. If costs increase proportionately, there
are no economies of scale; if costs increase by a greater amount,
there are diseconomies of scale; if costs increase by a lesser
amount; there are positive economies of scale. When combined,
economies of scale and diseconomies of scale lead to ideal firm size
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theory, which states that per-unit costs decrease until they reach a
certain minimum, then increase as the firm size increases further.
Economies of scale refers to the decreased per unit cost as output
increases. More clearly, the initial investment of capital is diffused
(spread) over an increasing number of units of output, and
therefore, the marginal cost of producing a good or service
decreases as production increases (note that this is only in an
industry that is experiencing economies of scale)
Economies of scale tend to occur in industries with high capital costs
in which those costs can be distributed across a large number of
units of production (both in absolute terms, and, especially, relative
to the size of the market). A common example is a factory. An
investment in machinery is made, and one worker, or unit of
production, begins to work on the machine and produces a certain
number of goods. If another worker is added to the machine he or
she is able to produce an additional amount of goods without
adding significantly to the factory's cost of operation. The amount
of goods produced grows significantly faster than the plant's cost of
operation. Hence, the cost of producing an additional good is less
than the good before it, and an economy of scale emerges.
Economies of scale are also derived partially from learning by doing.
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Chapter 3
Dynamics of Substitution, budgeting
and Functions of Production
Law of substitution states that the scarcer a good the greater
its substitution value, its marginal utility rises relative to the
marginal utility of the good that has become plentiful
In economics, the marginal rate of substitution is the rate at
which a consumer is ready to give up one good in exchange
for another good while maintaining the same level of
satisfaction.
A consumer's budget line characterizes on a graph the
maximum amounts of goods that the consumer can afford. In
a two good case, we can think of quantities of good X on the
horizontal axis and quantities of good Y on the vertical axis.
The term is often used when there are many goods, and
without reference to any actual graph.
A budget is a description of a financial plan. It is a list of
estimates of revenues to and expenditures by an agent for a
stated period of time. Normally a budget describes a period in
the future not the past.
The condition that exists when the last PKR spent on one good
provides the same marginal utility as the last PKR spent on
every other good. In consumer equilibrium, you allocate
income between the purchase of different goods in such a
way that you cannot increase your level of utility, that is, you
have achieved utility maximization. In indifference curve
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analysis, this occurs where the budget line is tangent to the
highest reachable indifference curve. With this consumption
bundle, the ratio of prices is equal to the ratio of marginal
utilities. This means that the willingness of the consumer to
trade one good for the other is exactly the same as the ability
to trade the two goods in the market.
Although a consumer’s demand curve for any good x is likely
to be downward sloping we cannot be certain of this because
of the presence of the income effect of a price change.
Whenever a price changes, that change will affect the demand
for the good in two ways:
The price of this good, relative to others has changed. This
induces a substitution effect. The change in relative prices will
lead to a re-allocation of spending between goods. Fewer of
the good which has become relatively more expensive will be
purchased and more of the good which has become relatively
less expensive will be bought. The substitution effect will
always be negative: a change in the price of a good will lead to
a change in the opposite direction in the quantity demanded
of it.
A price change (with a fixed level of money income) will
change the consumer’s real income (the purchasing power of
the money income). As the consumer’s real income is
changed, there will be a change in the amount of this good
(and others) purchased. However, the direction of this change
is uncertain. If the good in question is a normal good, higher
real income will increase the quantity demanded. Conversely,
if the good is an inferior good, higher real income will
decrease the quantity demanded.
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The demand curve for a good describes the overall
relationship between price and quantity demanded, and so
incorporates both the substitution effect and the real income
effect of a price change.
The substitution effect can be identified by asking how much
demand for the good would change if its price changes, and
The consumer is compensated for a price increase (or
financially penalized for a price fall) by just the amount
required to prevent the consumer from gaining more utility
than he or she had prior to the price change.
Production refers to the economic process of converting of
inputs into outputs and is a field of study in microeconomics.
Production uses resources to create a good or service that is
suitable for exchange. This can include manufacturing, storing,
shipping, and packaging. Some economists define production
broadly as all economic activity other than consumption. They
see every commercial activity other than the final purchase as
some form of production.
Production is a process, and as such it occurs through time
and space. Because it is a flow concept, production is
measured as a “rate of output per period of time”. There are
three aspects to production processes:
•
the quantity of the good or service produced,
•
the form of the good or service created,
•
The temporal and spatial distribution of the good or
service produced.
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A production process can be defined as any activity that
increases the similarity between the pattern of demand for
goods and services, and the quantity, form, and distribution of
these goods and services available to the market place.
Production is more efficient when the same output results
from less input. The “rate of efficiency” is simply the amount
of (or value of) outputs divided by the amount of (or value of)
inputs. If a production process uses 50 units of input (or PKR
5000 worth of inputs) to produce one unit of output it is more
efficient than a process that uses 55 units of input (or PKR
5500 worth of inputs) to produce the same level of output. It
is said to be 10% more efficient ({55-50}/50=1/10=10%).
The inputs or resources used in the production process are
called factors of production by economists. The myriad of
possible inputs are usually grouped into six categories. These
factors are:
•
Raw materials
•
Machinery
•
Labor services
•
Capital goods
•
Land
•
Entrepreneur
In the “long run”, all of these factors of production can be
adjusted by management. The “short run”, however, is
defined as a period in which at least one of the factors of
production is fixed.
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A fixed factor of production is one whose quantity cannot
readily be changed. Examples include major pieces of
equipment, suitable factory space, and key managerial
personnel.
A variable factor of production is one whose usage rate can be
changed easily. Examples include electrical power
consumption, transportation services, and most raw material
inputs. In the short run, a firm’s “scale of operations”
determines the maximum number of outputs that can be
produced. In the long run, there are no scale limitations.
The total product (or total physical product TPP) identifies
what outputs are possible using various levels of the input.
This can be displayed in either a chart that lists the output
level corresponding to various levels of input, or a graph that
summarizes the data into a “total product curve”. The diagram
shows a typical total product curve.
The average physical product (APP) is the total production
divided by the number of units of input employed. It is the
output of each unit of input. If there are 10 employees
working on a production process that manufactures 50 units
per day, then the average product of variable labor input is 5
units per day.
The average product typically varies as more of the input is
employed, so this relationship can also be expressed as a chart
or as a graph.
The marginal physical product of an input is the extra product
or output added by 1 extra unit of that input while other
inputs are held constant or it can be defined as a change in
total output due to a one unit change in the variable input or
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alternatively the rate of change in total output due to an
infinitesimally small change in the variable input (called the
continuous marginal product).
Because the marginal product drives changes in the average
product, we know that when the average physical product is
falling, the marginal physical product must be less than the
average. Likewise, when the average physical product is rising,
it must be due to a marginal physical product greater than the
average.
MPP keeps increasing until it reaches its maximum. Until this
point every additional unit has been adding more value to the
total product than the previous one. From this point onwards,
every additional unit adds less to the total product compared
to the previous one – MPP is decreasing. But the average
product is still increasing till MPP touches APP. At this point,
an additional unit is adding the same value as the average
product. From this point onwards, APP starts to reduce
because every additional unit is adding less to APP than the
average product. But the total product is still increasing
because every additional unit is still contributing positively.
Therefore, during this period, both, the average as well as
marginal products, are decreasing, but the total product is still
increasing. Finally we reach a point when MPP crosses the xaxis. At this point every additional unit starts to diminish the
product of previous units, possibly by getting into their way.
Therefore the total product starts to decrease at this point.
A production function is a function that specifies the output
of a firm, an industry, or an entire economy for all
combinations of inputs. A meta-production function
(sometimes metaproduction function) compares the practice
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of the existing entities converting inputs X into output y to
determine the most efficient practice production function of
the existing entities. Put another way, given the set of all
technically feasible combinations of output and inputs, only
the combinations encompassing a maximum output for a
specified set of inputs would constitute the production
function. Alternatively, a production function can be defined
as the specification of the minimum input requirements
needed to produce designated quantities of output, given
available technology. It is usually presumed that unique
production functions can be constructed for every production
technology.
To simplify the interpretation of a production function, it is
common to divide its range into 3 stages.
In stage 1, fixed inputs are underutilized.
In Stage 2, output increases at a decreasing rate, and the
average and marginal physical product is declining. However
the average product of fixed inputs is still rising. In this stage,
the employment of additional variable inputs increase the
efficiency of fixed inputs but decrease the efficiency of
variable inputs.
In Stage 3, too much variable input is being used relative to
the available fixed inputs: variable inputs are over utilized.
Both the efficiency of variable inputs and the efficiency of
fixed inputs decline through out this stage. At the boundary
between stage 2 and stage 3, fixed input is being utilized most
efficiently and short-run output is maximum
In economics, diminishing returns (also called diminishing
marginal returns) refers to how the marginal production of a
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factor of production starts to progressively decrease as the
factor is increased, in contrast to the increase that would
otherwise be normally expected. According to this
relationship, in a production system with fixed and variable
inputs (say factory size and labor), there will be a point
beyond which each additional unit of the variable input (i.e.,
man-hours) yields smaller and smaller increases in outputs,
also reducing each worker's mean productivity. Conversely,
producing one more unit of output will cost increasingly more
(owing to the major amount of variable inputs being used, to
little effect).
This concept is also known as the law of diminishing marginal
returns or the law of increasing relative cost.
Suppose that one kilogram of seed applied to a plot of land of
a fixed size produces one ton of crop. You might expect that
an additional kilogram of seed would produce an additional
ton of output. However, if there are diminishing marginal
returns, that additional kilogram will produce less than one
additional ton of crop (ceteris paribus). For example, the
second kilogram of seed may only produce a half ton of extra
output. Diminishing marginal returns also implies that a third
kilogram of seed will produce an additional crop that is even
less than a half ton of additional output, say, one quarter of a
ton.
In economics, the term "marginal" is used to mean on the
edge of productivity in a production system. The difference in
the investment of seed in these three scenarios is one
kilogram — "marginal investment in seed is one kilogram."
And the difference in output, the crops, is one ton for the first
kilogram of seeds, a half ton for the second kilogram, and one
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quarter of a ton for the third kilogram. Thus, the marginal
physical product (MPP) of the seed will fall as the total
amount of seed planted rises. In this example, the marginal
product (or return) equals the extra amount of crop produced
divided by the extra amount of seeds planted.
A consequence of diminishing marginal returns is that as total
investment increases, the total return on investment as a
proportion of the total investment (the average product or
return) decreases. The return from investing the first kilogram
is 1 t/kg. The total return when 2 kg of seed are invested is
1.5/2 = 0.75 t/kg, while the total return when 3 kg are
invested is 1.75/3 = 0.58 t/kg.
Another example is a factory that has a fixed stock of capital,
or tools and machines, and a variable supply of labor. As the
firm increases the number of workers, the total output of the
firm grows but at an ever-decreasing rate. This is because
after a certain point, the factory becomes overcrowded and
workers begin to form lines to use the machines. The long-run
solution to this problem is to increase the stock of capital, that
is, to buy more machines and to build more factories.
In production, returns to scale refer to changes in output
subsequent to a proportional change in all inputs (where all
inputs increase by a constant factor). If output increases by
that same proportional change then there are constant
returns to scale (CRTS). If output increases by less than that
proportional change, there are decreasing returns to scale
(DRS). If output increases by more than that proportion, there
are increasing returns to scale (IRS)
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Short example: where all inputs increase by a factor of 2, new
values for output should be:
Twice the previous output given = a constant return to scale
(CRTS)
Less than twice the previous output given = a decreased
return to scale (DRS)
More than twice the previous output given = an increased
return to scale (IRS)
Assuming that the factor costs are constant, a firm
experiencing CRTS will have constant average costs, a firm
experiencing DRS will have increasing average costs and a firm
experiencing IRS will have decreasing average costs.
Economies of scale and diseconomies of scale refer to an
economic property of production that affects cost if quantity
of all input factors is increased by some amount. If costs
increase proportionately, there are no economies of scale; if
costs increase by a greater amount, there are diseconomies of
scale; if costs increase by a lesser amount; there are positive
economies of scale. When combined, economies of scale and
diseconomies of scale lead to ideal firm size theory, which
states that per-unit costs decrease until they reach a certain
minimum, then increase as the firm size increases further.
Economies of scale refers to the decreased per unit cost as
output increases. More clearly, the initial investment of capital
is diffused (spread) over an increasing number of units of
output, and therefore, the marginal cost of producing a good
or service decreases as production increases (note that this is
only in an industry that is experiencing economies of scale)
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Economies of scale tend to occur in industries with high
capital costs in which those costs can be distributed across a
large number of units of production (both in absolute terms,
and, especially, relative to the size of the market). A common
example is a factory. An investment in machinery is made, and
one worker, or unit of production, begins to work on the
machine and produces a certain number of goods. If another
worker is added to the machine he or she is able to produce
an additional amount of goods without adding significantly to
the factory's cost of operation. The amount of goods
produced grows significantly faster than the plant's cost of
operation. Hence, the cost of producing an additional good is
less than the good before it, and an economy of scale
emerges. Economies of scale are also derived partially from
learning by doing.
A business (also called a company, enterprise or firm) is a
legally recognized organization designed to provide goods
and/or services to consumers. Businesses are predominant in
capitalist economies, most being privately owned and formed
to earn profit that will increase the wealth of its owners and
grow the business itself. The owners and operators of a
business have as one of their main objectives the receipt or
generation of a financial return in exchange for work and
acceptance of risk. Notable exceptions include cooperative
enterprises and state-owned enterprises. Businesses can also
be formed not-for-profit or be state-owned.
Although forms of business ownership vary by jurisdiction,
there are several common forms:
Sole proprietorship: A sole proprietorship is a business owned
by one person. The owner may operate on his or her own or
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may employ others. The owner of the business has personal
liability of the debts incurred by the business.
Partnership: A partnership is a form of business in which two
or more people operate for the common goal which is often
making profit. In most forms of partnerships, each partner has
personal liability of the debts incurred by the business. There
are three typical classifications of partnerships: general
partnerships, limited partnerships, and limited liability
partnerships.
Corporation: A corporation is either a limited or unlimited
liability entity that has a separate legal personality from its
members. A corporation can be organized for-profit or notfor-profit. A corporation is owned by multiple shareholders
and is overseen by a board of directors, which hires the
business's managerial staff. In addition to privately-owned
corporate models, there are state-owned corporate models.
Cooperative: Often referred to as a "co-op", a cooperative is a
limited liability entity that can organize for-profit or not-forprofit. A cooperative differs from a corporation in that it has
members, as opposed to shareholders, who share decisionmaking authority. Cooperatives are typically classified as
either consumer cooperatives or worker cooperatives.
Cooperatives are fundamental to the ideology of economic
democracy.
There are many types of businesses, and because of this,
businesses are classified in many ways. One of the most
common focuses on the primary profit-generating activities of
a business:
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Agriculture and mining businesses are concerned with the
production of raw material, such as plants or minerals.
Financial businesses include banks and other companies that
generate profit through investment and management of
capital.
Information businesses generate profits primarily from the
resale of intellectual property and include movie studios,
publishers and packaged software companies.
Manufacturers produce products, from raw materials or
component parts, which they then sell at a profit. Companies
that make physical goods, such as cars or pipes, are
considered manufacturers.
Real estate businesses generate profit from the selling,
renting, and development of properties, homes, and buildings.
Retailers and Distributors act as middle-men in getting goods
produced by manufacturers to the intended consumer,
generating a profit as a result of providing sales or distribution
services. Most consumer-oriented stores and catalogue
companies are distributors or retailers.
Service businesses offer intangible goods or services and
typically generate a profit by charging for labor or other
services provided to government, other businesses or
consumers. Organizations ranging from house decorators to
consulting firms to restaurants and even to entertainers are
types of service businesses.
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Transportation businesses deliver goods and individuals from
location to location, generating a profit on the transportation
costs
Utilities produce public services, such as heat, electricity, or
sewage treatment, and are usually government chartered.
There are many other divisions and subdivisions of businesses.
The authoritative list of business types for North America is
generally considered to be the North American Industry
Classification System, or NAICS. The equivalent European
Union list is the NACE.
In economics, fixed costs are business expenses that are not
dependent on the activities of the business. They tend to be
time-related, such as salaries or rents being paid per month.
This is in contrast to variable costs, which are volume-related
(and are paid per quantity).
Variable costs are expenses that change in proportion to the
activity of a business. In other words, variable cost is the sum
of marginal costs. It can also be considered normal costs.
Along with fixed costs, variable costs make up the two
components of total cost.
In management accounting, fixed costs are defined as
expenses that do not change in proportion to the activity of a
business, within the relevant period. For example, a retailer
must pay rent and utility bills irrespective of sales.
Along with variable costs, fixed costs make up one of the two
components of total cost. In the most simple production
function, total cost is equal to fixed costs plus variable costs.
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In
economics and finance, marginal cost is the change in total
cost that arises when the quantity produced changes by one
unit. That is, it is the cost of producing one more unit of a
good. Note that the marginal cost may change with volume,
and so at each level of production, the marginal cost is the
cost of the next unit produced.
In general terms, marginal cost at each level of production
includes any additional costs required to produce the next
unit. If producing additional vehicles requires, for example,
building a new factory, the marginal cost of those extra
vehicles includes the cost of the new factory. In practice, the
analysis is segregated into short and long-run cases, and over
the longest run, all costs are marginal. At each level of
production and time period being considered, marginal costs
include all costs which vary with the level of production, and
other costs are considered fixed costs.
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A textbook distinction is made between short-run and longrun marginal cost. The former takes fixed costs as unchanged,
for example, the capital equipment and overhead of the
producer, any change in its production involves only changes
in the inputs of labor, materials and energy. The latter allows
all inputs, including capital items (plant, equipment, buildings)
to vary.
Average cost-Various definitions
Total costs divided by total output
Total doctor and/or hospital charges divided by total cases.
A book value for stocks (inventory) calculated using a moving
average of the price of stocks received....more on average cost
One of three methods to determine the cost basis of the
mutual fund shares you sell. Under this method, you
determine the average price of all shares.
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Opportunity cost is the value of the next-best choice available
to someone who has picked between several mutually
exclusive choices. It is a key concept in economics. It is a
calculating factor used in mixed markets which favor social
change in favor of purely individualistic economics. It has been
described as expressing "the basic relationship between
scarcity and choice." The notion of opportunity cost plays a
crucial part in ensuring that scarce resources are used
efficiently. Thus, opportunity costs are not restricted to
monetary or financial costs: the real cost of output forgone,
lost time, swag, pleasure or any other benefit that provides
utility should also be considered opportunity costs.
The concept of an opportunity cost was first developed by
John Stuart Mill.
A person who has PKR 15 can either buy a CD or a shirt. If he
buys the shirt the opportunity cost is the CD and if he buys the
CD the opportunity cost is the shirt. If there are more choices
than two, the opportunity cost is still only one item, never all
of them.
A person who invests PKR 10,000 in a stock denies herself or
himself the interest that could have accrued by leaving the
PKR 10,000 in a bank account instead. The opportunity cost of
the decision to invest in stock is the value of the interest.
A person who sells stock for PKR 10,000 denies himself or
herself the opportunity to sell the stock for a higher price in
the future, inheriting an opportunity cost equal to future price
minus sale price.
An organization that invests PKR 1 million in acquiring a new
asset instead of spending that money on maintaining its
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existing asset portfolio incurs the increased risk of failure of its
existing assets. The opportunity cost of the decision to acquire
a new asset is the financial security that comes from the
organization's spending the money on maintaining its existing
asset portfolio.
If a city decides to build a hospital on vacant land it owns, the
opportunity cost is the value of the benefits forgone of the
next best thing that might have been done with the land and
construction funds instead. In building the hospital, the city
has forgone the opportunity to build a sports center on that
land, or a parking lot, or the ability to sell the land to reduce
the city's debt, since those uses tend to be mutually exclusive.
Also included in the opportunity cost would be what
investments or purchases the private sector would have
voluntarily made if it had not been taxed to build the hospital.
The total opportunity costs of such an action can never be
known with certainty, and are sometimes called "hidden
costs" or "hidden losses" as what has been prevented from
being produced cannot be seen or known. Even the possibility
of inaction is a lost opportunity. In this example, to preserve
the scenery as-is for neighboring areas, perhaps including
areas that it itself owns.
Opportunity cost is assessed in not only monetary or material
terms, but also in terms of anything which is of value. For
example, a person who desires to watch each of two
television programs being broadcast simultaneously, and does
not have the means to make a recording of one, can watch
only one of the desired programs. Therefore, the opportunity
cost of watching Dallas could be enjoying Dynasty. In a
restaurant situation, the opportunity cost of eating steak
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could be trying the salmon. For the diner, the opportunity cost
of ordering both meals could be twofold - the extra Rs 20 to
buy the second meal, and his reputation with his peers, as he
may be thought gluttonous or extravagant for ordering two
meals. A family might decide to use a short period of vacation
time to visit Disneyland rather than doing household
improvements. The opportunity cost of having happier
children could therefore be a remodeled bathroom.
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Chapter 4
Market Behavior/Game theory
A perfectly competitive firm is one that can sell all the output
it wants at the going market price. Competitive firms are
assumed to maximize their profits. To maximize profits the
competitive firm will choose the output level at which price
equals the marginal cost production i.e. P = MC.
Diagrammatically the competitive firms equilibrium will come
where the rising MC curve intersects the horizontal demand
curve.
Variable costs must be taken in to consideration in
determining a firm short run shut down point. Below the shut
down point the firm loses more than its fixed costs. It will
therefore be shutdown and produce nothing when price falls
below the shut down price
A competitive industry long run supply curve must take in to
account the entry of new firm and exodus of old ones. In the
long run all of the firms’ commitments expire. It will stay in
business only if price is at least as high as long run average
costs. These costs includes out of pocket payments to labor,
lenders material suppliers, or landlords or opportunity costs
such as the returns on the property assets owned by the firm
Each firms rising MC curve is its supply curve. To obtain the
supply curve of a group of competitive firms separate
competitive curves are added horizontally. The supply curve of
the industry hence represents the marginal cost curve for the
competitive industries as a whole.
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Because firms can adjust productions over time two different
time periods can be distinguished. (a) short run equilibrium
when variable factors like labor change but fixed factors like
capital and the number of firms do not change (b) long run
equilibrium when the number of firms and plants and all other
conditions adjust completely to the new demand conditions.
In the long run when firms are free to enter and leave the
industry and where no one firm has any particular advantage
of skill or allocation competition will eliminate any excess
profits earned by existing firms in the industry. So just as free
exist means price can not fall below the zero profit point, free
entry means process can not exceed long run average cost in
long run equilibrium.
When an industry can expand by replication without pushing
up the prices of its factors of production, the resulting long
run supply curve will be horizontal. When an industry uses
factors specific to it, its long run supply curve will slope
upward.
The analysis of competitive markets sheds light on the
efficient organizations of a society. Allocative efficiency occurs
when there is no way of reorganizing production and
distribution such that every ones satisfaction can be
improved. Put differently an economy is efficient when no
individual can be made better-off without making another
individual worse off.
Under ideal conditions a competitive economy attains
allocative efficiency. Efficiency requires that all firms are
perfect competitors and there are no externalities like
pollution or improved information, efficiency comes because
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(a) when consumer maximize satisfaction, the marginal utility
just equals the price (b) when competitive producers supply
goods, they choose output so the marginal cost just equals
price © Since MU= P and MC = P it follows that a good under
perfect competition just equals its marginal utility valuation.
The outcome of competitive markets even when efficient may
not be socially desirable, Competitive markets by themselves
will not necessary ensure outcome that corresponds to the
societies ideals about the fair distribution of income and
consumption. Societies modify the lassies faire equilibrium to
change the income distribution to correct for a perceived
unfairness of money vote of demand
A monopoly, as many people know, is a market condition in
which only one vendor (usually a large corporation) is in play.
There may be other somewhat similar businesses, but a
monopoly exists when only one business or individual can
provide a product or service. In an oligopoly, the product or
service may be available from more than one vendor or
merchant, but only a few big players dominate the market and
make competition very difficult for new entries in the field.
Examples of monopolies are difficult to produce. Electricity,
for example, is generally available from only one "electric
company" in any given market. Water and cable television are
equally exclusive. During the 1990s, Microsoft commanded
such a large portion of the computer operating system
environment, and demonstrated such a propensity to absorb
upstart competitors, that it was believed to be a monopoly as
well.
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Examples of oligopolies are considerably more plentiful. The
automotive industry, for example, has many competitors but
is dominated by General Motors, Ford, Chrysler, Honda, and
Toyota. Breakfast cereal is also such an excellent example of
oligopoly. Sugar and Cement mafias are their best examples
in Pakistan.
While monopolies and oligopolies are representative of
considerably different market conditions, they do bear some
important similarities. Consumers are at a distinct price
disadvantage in both conditions, as prices for products are
dictated by a single company in a monopoly environment and
commanded by only a few select merchants in an oligopoly
condition. Selection is similarly limited as products are
designed and offered by a very limited consortium in both
arrangements.
Despite their similarities, there are some distinct differences
between monopolies and oligopolies. While a monopoly does
severely restrict consumer choices, oligopoly conditions do
allow for some competition among the major players. This
competition can even induce price wars, as has been
demonstrated by fast-food giants, automotive manufacturers
and even cola companies. The most significant difference,
however, is that oligopolies are a common market condition
while monopolies are forbidden under federal regulations in
case of most of the countries.
Oligopolies and monopolies, for all their similarities and
differences, both dictate a considerable market disadvantage
for consumers. In both environments, consumers have little
choice but to buy the products or services offered by the one
or few companies and complete the transaction at whatever
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price was set by the organization. An ideal free market
economy, the type commonly associated with capitalism, puts
the consumer in charge by eliminating the influence of major
monopoly or oligopoly players.
There are two extreme forms of market structure: monopoly
and, its opposite, perfect competition. Perfect competition is
characterized by many buyers and sellers, many products that
are similar in nature and, as a result, many substitutes. Perfect
competition means there are few, if any, barriers to entry for
new companies, and prices are determined by supply and
demand. Thus, producers in a perfectly competitive market
are subject to the prices determined by the market and do not
have any leverage. For example, in a perfectly competitive
market, should a single firm decide to increase its selling price
of a good, the consumers can just turn to the nearest
competitor for a better price, causing any firm that increases
its prices to lose market share and profits.
Marginal revenue is the extra revenue generated when a
monopolistically competitive firm sells one more unit of
output. It plays a key role in the profit-maximizing decision of
a monopolistically competitive firm relative to marginal cost. A
monopolistically competitive firm maximizes profit by
equating marginal revenue, the extra revenue generated from
production, with marginal cost, the extra cost of production. If
these two marginal's are not equal, then profit can be
increased by producing more or less output. The relation
between marginal revenue and the quantity of output
produced depends on market structure. For a perfectly
competitive firm, marginal revenue is equal to price and
average revenue, all three of which are constant. For a
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monopoly, monopolistically competitive, or oligopoly firm,
marginal revenue is less than average revenue and price, all
three of which decrease with larger quantities of output. The
constant or decreasing nature of marginal revenue is a prime
indication of the market control of a firm.
Marginal revenue can be represented in a table or as a curve.
For a perfectly competitive firm, the marginal revenue curve is
a horizontal, or perfectly elastic, line. For a monopoly,
oligopoly, or monopolistically competitive firm, the marginal
revenue curve is negatively sloped.
The marginal revenue received by a monopolistically
competitive firm is the change in total revenue divided by the
change in quantity, often expressed as this simple equation:
Marginal revenue = change in total revenue/ change quantity
Market control means these market structures face
negatively-sloped demand curves. As such, the price received
is not fixed, but depends on the quantity of output sold, and
so too does marginal revenue
Quantity
Price
0
1
2
3
4
5
6
7
8
9
5.25
5.20
5.15
5.10
5.05
5.00
4.95
4.90
4.85
4.80
Total Revenue Marginal
Revenue
0.0
5.20
5.20
10.30
5.10
15.30
5.00
20.20
4.90
25.00
4.80
29.70
4.70
34.30
4.60
38.80
4.50
43.20
4.40
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10
4.75
47.50
4.30
The table summarizes the marginal revenue received by a
hypothetical firm, KFC. KFC is one of thousands of restaurants
that offer meals to lunch-hungry buyers. KFC is a
monopolistically competitive firm with minimal market
control, facing a negatively-sloped demand curve. To sell a
larger number of Broasts, KFC must lower the price. The first
column is the quantity of Broasts sold, ranging from 0 to 10.
The second column is the price KFC receives for selling this
meal, which ranges from PKR 4.75 to PKR 5.25 per Broast. The
third column is the total revenue KFC receives for producing
and selling his Broasts.
Marginal revenue in the forth column is found by dividing the
change in total revenue (from the third column) by the change
in quantity (from the first column). For example KFC increases
production and sales from 4 Broasts to 5, his total revenue
increases from Rs 20.20 to Rs 25, an increase of Rs 4.80. As
such, the marginal revenue of producing the fifth Broast is Rs
4.80 (= Rs 4.80/1). Each value in the fourth column is
calculated in the same way.
One obvious point is that marginal revenue decreases with the
quantity of Broasts produced. A second point is that marginal
revenue is less than the price of Broast for each quantity sold.
The price of the fifth Broast is Rs 5, but the marginal revenue
generated by the fifth Broast is only Rs 4.80. Marginal revenue
is less than price. And because price is average revenue,
marginal revenue is also less than average revenue.
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In economic theory, imperfect competition is the competitive
situation in any market where the conditions necessary for
perfect competition are not satisfied. It is a market structure
that does not meet the conditions of perfect competition.
Forms of imperfect competition include:
•
Monopoly, in which there is only one seller of a good.
•
Oligopoly, in which there is a small number of sellers.
•
Monopolistic competition, in which there are many
sellers producing highly differentiated goods.
•
Monopsony, in which there is only one buyer of a
good.
•
Oligopsony, in which there is a small number of buyers.
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There may also be imperfect competition in markets
due to buyers or sellers lacking information about
prices and the goods being traded.
It is a common market structure where many competing
producers sell products that are differentiated from one
another (that is, the products are substitutes, but are not
exactly alike, similar to brand loyalty). Many markets are
monopolistically competitive; common examples include the
markets for restaurants, cereal, clothing, shoes, and service
industries in large cities.
Monopolistically competitive markets have the following
characteristics:
There are many producers and many consumers in a given
market, and no business has total control over the market
price.
Consumers perceive that there are non-price differences
among the competitors' products.
There are few barriers to entry and exit.
Producers have a degree of control over price.
The characteristics of a monopolistically competitive market
are almost the same as in perfect competition, with the
exception of monopolistic competition having heterogeneous
products, and that monopolistic competition involves a great
deal of non-price competition (based on subtle product
differentiation). A firm making profits in the short run will
break even in the long run because demand will decrease and
average total cost will increase. This means in the long run, a
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monopolistically competitive firm will make zero economic
profit. This gives the amount of influence over the market;
because of brand loyalty, it can raise its prices without losing
all of its customers. This means that an individual firm's
demand curve is downward sloping, in contrast to perfect
competition, which has a perfectly elastic demand schedule.
Short-run equilibrium of the firm under monopolistic
competition
Long-run equilibrium of the firm under monopolistic
competition
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Economic life is full of uncertainty. Consumers face uncertain
incomes and employment patterns as well as the threat of
catastrophic losses; businesses have uncertain costs, and their
revenues contain uncertainties about price and production.
In well-functioning markets, arbitrage, speculation, and
insurance help smooth out the unavoidable risks. Speculators
are people who buy and sell assets or commodities with an
eye to making profits on price differentials across markets.
They move goods across regions from low-price to high-price
markets, across time from periods of abundance to periods of
scarcity, and even across uncertain states of nature to periods
when chance makes goods scarce.
The profit-seeking action of speculators and arbitragers tends
to create certain equilibrium patterns of price over space and
time. These market equilibriums are zero-profit outcomes
where the marginal costs and marginal utilities in different
regions, times, or uncertain states of nature are in balance. To
the extent that speculators moderate price and consumption
instability, they are part of the invisible-hand mechanism that
performs the socially useful function of reallocating goods
from feast times (when prices are low) to famine times (when
prices are high).
Speculative markets allow individuals to hedge against
unwelcome risks. The economic principle of risk aversion,
which derives from diminishing marginal utility, implies that
individuals will not accept risky situations with zero expected
value. Risk aversion implies that people will buy insurance to
reduce the disastrous declines in utility from fire, death, or
other calamities.
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Insurance and risk spreading tend to stabilize consumption in
different states of nature. Insurance takes large individual
risks and spreads them so broadly that they become
acceptable to a large number of individuals. Insurance is
beneficial because, by helping to equalize consumption across
different uncertain states, it raises the expected level of utility.
The conditions for operation of efficient insurance markets are
stringent: there must be large numbers of independent
events, with little chance of moral hazard or adverse selection.
When market failures such as adverse selection arise, prices
can become distorted or markets may simply not exist. If
private insurance markets fail, the government may step in to
provide social insurance. Even in the most laissez-faire of
advanced market economies today, governments insure
against unemployment and health risks in old age.
Economic life contains many situations of strategic interaction
among firms, households, governments, or others. Game
theory analyzes the way that two or more parties, who
interact in an arena such as a market, choose actions or
strategies that jointly affect each participant.
The basic structure of a game includes the players, who have
different actions or strategies, and the payoffs, which describe
the profits or other benefits that the players obtain in each
outcome. The key new concept is the payoff table of a game,
which shows the strategies and the payoffs or profits of the
different players.
The key to choosing strategies in game theory is for players to
think through both their own and their opponent's goals,
never forgetting that the other side is doing the same. When
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playing a game in economics or any other field, assume that
your opponent will choose his or her best option. Then pick
your strategy so as to maximize your benefit, always assuming
that your opponent is similarly analyzing your options.
Sometimes a dominant strategy is available, one that is best
no matter what the opposition does. More often, we find the
Nash equilibrium (or non cooperative equilibrium) a useful
equilibrium concept. A Nash equilibrium is one in which no
player can improve his or her payoff given the other player's
strategy. Sometimes, parties can collude or cooperate, which
produces the cooperative equilibrium.
A Nash equilibrium produces an efficient outcome in Adam
Smith's invisible-hand game. Here, no collusive firms produce
at prices equal to marginal costs, and the no cooperative
equilibrium is efficient. In such situations, cooperation leads to
inefficient production.
Sometimes, however, no cooperative behavior leads to social
ruin, as when competitors pollute the planet or engage in
dangerous arms races. Winner-take-all games, such as
lawsuits or athletic contests, can induce the entry of too many
contestants and increase the inequality of fame and incomes.
Normal
Normal
price A
from B
B
Price war from B
A
B
price from A
10
10
-10
-100
Price war from A
A
-100
B
-10
A
-50
B
-50
Two parties A and B are in competition. To devise their
strategy when A goes in to price war than he goes in negative
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zone higher than B. Conversely when B goes in to price war he
goes in to negative higher than A. In case both tries was price
strategy than they both incur loss. So best strategy for both is
to go at normal price.
Free trade policy Protection
from US
from US
Free trade policy
1
from Japan
US
6000
US
Japan
3000
Japan
Protection policy
3
from Japan
US
4800
US
Japan
3200
Japan
policy
2
6100
1900
4
5000
2000
In column 1 each can enjoy benefit of free trade by reducing
import tariffs. However in column 2 and 3 they can increase
their gains by cheating other. As regards column 4 it would be
worst off in all words
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Chapter 5
Income and Wealth
Distribution theory is concerned with the basic question of for
whom the economic goods are to be produced. In examining
how the different factors of production land labor and capital
get priced in the market. Distribution theory considers how
supplies and demands for these factors are linked and how
they determine all kinds of wages, rents, interest rates and
profits.
Income refers to the total receipts are cash earned by a
person or household during a given time period (usually a
year). Income consists of labor earnings, property income and
government transfer payments (mostly consists of social
security payments to the elderly).
National income consists of labor earnings and property
income generated by an economy in a year. Government
takes share of that national income in the form of taxes and
gives back part of what it collects as transfer payments. The
post tax personal income of an individual includes the returns
on all the factors of production, labor and property that the
individual owns plus transfer payments from the government
less taxes.
In economics, the marginal product or marginal physical
product is the extra output produced by one more unit of an
input (for instance, the difference in output when a firm's
labor is increased from five to six units). Assuming that no
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other inputs to production change, the marginal product of a
given input X (labor) can be expressed as
MP = ∆ Y/= ∆ X
Where ΔX and ΔY is the change of workers in a firm and
quantity of production output, respectively.
In the neoclassical theory of competitive markets, the
marginal product of labor equals the real wage. In aggregate
models of perfect competition, in which a single good is
produced and that good is used both in consumption and as a
capital good, the marginal product of capital equals its rate of
return.
Marginal product is the slope of the total product curve and is
given by:
MP = Total product/Quantity of labor units
The marginal revenue productivity theory of wages, also
referred to as the marginal revenue product of labor, is the
change in total revenue earned by a firm that results from
employing one more unit of labor. It is a neoclassical model
that determines, under some conditions, the optimal number
of workers to employ at an exogenously determined market
wage rate.
The marginal revenue product (MRP) of a worker is equal to
the product of the marginal product of labor (MP) and the
marginal revenue (MR), given by MR × MP = MRP. The theory
states that workers will be hired up to the point where the
Marginal Revenue Product is equal to the wage rate by a
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maximizing firm, because it is not efficient for a firm to pay its
workers more than it will earn in profits from their labor.
Monopoly is a market structure with a single firm selling a
unique good. As the only firm on the supply-side of the
market, monopoly is a price maker and has extensive market
control, facing a negatively-sloped demand curve. If a
monopoly wants to sell a larger quantity, then it must lower
the price. The marginal revenue curve reflects the degree of
market control held by a firm. For a perfectly competitive firm,
the marginal revenue curve is a horizontal, or perfectly elastic,
line. For a monopoly, oligopoly, or monopolistically
competitive firm, the marginal revenue curve is negatively
sloped and lies below the average revenue (demand) curve.
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Least cost rule
Costs are minimized when the marginal product per PKR of
input is equalized for each input. This holds for both perfect
and imperfect competitors in product market
Illustration through equation
Marginal product of labor/price of labor = marginal product of
land/price of land = 1/marginal revenue
Wages are the most common earnings of people. Perceived by
workers, clerks, managers, and employees in general, wages
and salaries constitute the core element in income for the
majority of active people. Similarly, many pension schemes
are based on wage levels and dynamics.
By contrast, the self-employed do not receive wages, but sell
directly their labor in the market. The property and enterprise
owners obtain income from rents, dividends, and other
financial instruments' gains. The unemployed in certain
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countries and under constraints receive public financial
support.
In another perspective, wages are a major determinant of
production costs.
Types of wages
Nominal wages are written down in contracts between the
employee and the organization. Real wages somehow correct
nominal wages for prices of goods and services bought by the
employee. In specific institutional settings, nominal wages
may be automatically and frequently adjusted to certain
inflation measures, resulting in a more or less constant real
wages.
Part of the wage may be paid in nature (e.g. fringe benefits),
but the core is usually paid with money. Some firms use stock
options as part of the remuneration package.
Determinants of Wages
Wage levels result from individual and collective negotiations
between the employees (and their representatives) with the
management (and the owners) of firms. In public bodies, laws
and negotiations decide wages.
Firms and organizations pay wages to employees usually
depending on working time and/or on results (production
made or objectives reached). Individual wage often depends
on occupied position in the organization as well as on
education, cumulated experience and seniority. Wages for the
same job outside the firm may serve as a conventional or
mandatory reference point.
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Wage differentiation is a widespread phenomenon: different
occupations and different industries pay working time at
uneven rates. Even wage segregation is common: certain jobs
are "socially" attributed to a certain gender or ethnicity, which
in turn might decide to widen the job it is "allowed" to
perform.
Wage dynamics
Wages are changed at discrete intervals of time, often a year,
possibly within a multi-year perspective plan.
Wage dynamics
determinants:
are
linked
to
the
following
main
1. Strength balances between employees and employers;
2. Previous and current profitability of employers;
3. Labor productivity increases;
4. Sales and employment perspectives;
5. Shortage of workers or, more often, abundance of
unemployed;
6. Past and forecasted inflation trends;
For certain jobs, international levels of wages and immigration
may be additional determinants, with a large pool of
emigrants being the source of international remittances, on
the one hand, and downward pressure on current domestic
wages, on the other.
Labor Market
More analytically, a firm's labor market can be purposefully
separated in internal market (within firm) and external
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market (in other firms and the unemployed). Internal market
is ruled by hierarchy and career processes, together with firmspecific wage policy. To a certain degree, external conditions
exert only a marginal role in internal negotiations. In fact,
employees have cumulated firm-specific skills, difficult to find
ready on the market. Seamless effective work requires mutual
trust, which in turn depends on stability of work for, at least, a
core of employees.
By contrast, external market is relevant when employees
choose a voluntary dismissal for getting better conditions
outside. When a relevant turnover takes place, the
management is possibly forced to choose another wage
policy.
Impact of wages on other variables
Higher wages mean higher income in most families; thus their
consumption will usually grow as well.
Total consumption will depend on consumption attitudes of
the other families, in particular of whose income heavily relies
on dividends. Immigrants may save part of their income to
send remittances home.
If total consumption grows, this will boost sales throughout
the industries, increasing productivity. This, in turn, is
conducive to a further growth in wages.
Through the Keynesian multiplier, income increase will be
followed again by consumption, giving rise to a positive
feedback loop.
If sales do not increase enough, the increase in wages will be
reflected in an increase of labor cost per unit of output. This,
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however, brings forth a very credible risk of inflation, with the
involved reduction of real income. A wages-prices spiral will
begin, with only nominal increase of both, keeping real things
to a large extent untouched (but provoking a lot of social
conflict).
On a more micro level, it is important to remember that wage
level and dynamics are a key feature for individual motivation
to work.
Land
In economics, land comprises all naturally occurring resources
whose supply is inherently fixed. Natural resources are
fundamental to the production of all goods, including capital
goods. Location values must not be confused with values
imparted by fixed capital improvements. In classical
economics, land is considered one of the three factors of
production (along with capital, and labor). Income derived
from ownership or control of natural resources is referred to
as rent
As a tangible asset land is represented in accounting as a fixed
asset or a capital asset.
Land, particularly geographic locations and mineral deposits,
has historically been the cause of much conflict and dispute;
land reform programmes, which are designed to redistribute
possession and/or use of geographic land, are often the cause
of much controversy, and conflicts over the economic rent of
mineral deposits have contributed to many civil wars,
particularly in Africa.
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Capital-Defined
In economics, capital or capital goods or real capital are
factors of production used to create goods or services that are
not themselves significantly consumed (though they may
depreciate) in the production process. Capital goods may be
acquired with money or financial capital. In finance and
accounting, capital generally refers to financial wealth
especially that used to start or maintain a business.
In classical economics, capital is one of three (or four, in some
formulations) factors of production. The others are land, labor
and (in some versions) organization, entrepreneurship, or
management. Goods with the following features are capital:
It can be used in the production of other goods (this is what
makes it a factor of production).
It was produced, in contrast to "land," which refers to
naturally occurring resources such as geographical locations
and minerals.
It is not used up immediately in the process of production
unlike raw materials or intermediate goods. (The significant
exception to this is depreciation allowance, which like
intermediate goods, is treated as a business expense.)
There was the further clarification that capital is a stock. As
such, its value can be estimated at a point in time, say
December 31. By contrast, investment, as production to be
added to the capital stock, is described as taking place over
time ("per year"), thus a flow.
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Earlier illustrations often described capital as physical items,
such as tools, buildings, and vehicles that are used in the
production process. Since at least the 1960s economists have
increasingly focused on broader forms of capital. For example,
investment in skills and education can be viewed as building
up human capital or knowledge capital, and investments in
intellectual property can be viewed as building up intellectual
capital. These terms lead to certain questions and
controversies discussed in those articles. Human development
theory describes human capital as being composed of distinct
social, imitative and creative elements:
Social capital is the value of network trusting relationships
between individuals in an economy.
Individual capital which is inherent in persons, protected by
societies, and trades labor for trust or money. Close parallel
concepts are "talent", "ingenuity", "leadership", "trained
bodies", or "innate skills" that cannot reliably be reproduced
by using any combination of any of the others above. In
traditional economic analysis individual capital is more usually
called labor.
Further classifications of capital that have been used in
various theoretical or applied uses include:
Financial capital which represents obligations, and is
liquidated as money for trade, and owned by legal entities. It
is in the form of capital assets, traded in financial markets. Its
market value is not based on the historical accumulation of
money invested but on the perception by the market of its
expected revenues and of the risk entailed.
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Natural capital which is inherent in ecologies and protected by
communities to support life, e.g. a river which provides farms
with water.
Infrastructural capital is non-natural support systems (e.g.
clothing, shelter, roads, personal computers) that minimize
need for new social trust, instruction, and natural resources.
(Almost all of this is manufactured, leading to the older term
manufactured capital, but some arises from interactions with
natural capital, and so it makes more sense to describe it in
terms of its appreciation/depreciation process, rather than its
origin: much of natural capital grows back, infrastructural
capital must be built and installed.)
In part as a result, separate literatures have developed to
describe both natural capital and social capital. Such terms
reflect a wide consensus that nature and society both function
in such a similar manner as traditional industrial
infrastructural capital, that it is entirely appropriate to refer to
them as different types of capital in themselves. In particular,
they can be used in the production of other goods, are not
used up immediately in the process of production, and can be
enhanced (if not created) by human effort.
There is also a literature of intellectual capital and intellectual
property law. However, this increasingly distinguishes means
of capital investment, and collection of potential rewards for
patent, copyright (creative or individual capital), and
trademark (social trust or social capital) instruments. The
word capital is what you have as a wealth.
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Use of Capital
One of the most important tasks of any economy, business, or
household is to allocate its capital across different possible
investments. Should a country devote its investment
resources to heavy manufacturing like steel or to information
technologies like the Internet? Should Intel build a Rs 4 billion
factory to produce the next generation of microprocessors?
Should Farmer Jones, hoping to improve his record keeping,
buy a customized accounting program or go with one of the
popular varieties available for around Rs100? All these
questions involve costly investments laying out money today
to obtain a return in the future. In deciding upon the best
investment, we need a measure for that yield or return on
capital. One important measure is the rate of return on
capital, which denotes the net dollar return per year for every
dollar of invested capital.
Let's consider the example of a rental car company. Ugly
Duckling Rental Company buys a used Ford for $ 10,000 and
rents it out for $ 2500 per year. After calculating all expenses
and ignoring any change in car pricing. Ugly Duckling earns a
net rental of $1200 each year. We say then that the rate of
return on the ford is 12 percent per year.
Rate of return (ROR)
rate of return (ROR), also known as return on investment
(ROI), rate of profit or sometimes just return, is the ratio of
money gained or lost (whether realized or unrealized) on an
investment relative to the amount of money invested. The
amount of money gained or lost may be referred to as
interest, profit/loss, gain/loss, or net income/loss. The money
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invested may be referred to as the asset, capital, principal, or
the cost basis of the investment. ROI is usually expressed as a
percentage rather than a fraction.
Time value of money
Investments generate cash flow to the investor to compensate
the investor for the time value of money.
Except for rare periods of significant deflation where the
opposite may be true, a dollar in cash is worth less today than
it was yesterday, and worth more today than it will be worth
tomorrow. The main factors that are used by investors to
determine the rate of return at which they are willing to invest
money include:
Estimates of future inflation rates
Estimates regarding the risk of the investment (e.g. how likely
it is that investors will receive regular interest/dividend
payments and the return of their full capital)
Whether or not the investors want the money available
(“liquid”) for other uses.
The time value of money is reflected in the interest rates that
banks offer for deposits, and also in the interest rates that
banks charge for loans such as home mortgages. The “riskfree” rate is the rate on U.S. Treasury Bills, because this is the
highest rate available without risking capital.
The rate of return which an investor expects from an
investment is called the Discount Rate. Each investment has a
different discount rate, based on the cash flow expected in
future from the investment. The higher the risk, the higher the
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discount rate (rate of return) the investor will demand from
the investment.
Concept of PV and NPV
Present value (PV) is the value on a given date of a future
payment or series of future payments, discounted to reflect
the time value of money and other factors such as investment
risk. Present value calculations are widely used in business and
economics to provide a means to compare cash flows at
different times on a meaningful "like to like" basis.
Formula:-present value= discount factor x (C1 i.e. expected
cash flow at time t)
Discount factor= 1/1+r
Example: - if you anticipate to receive Rs 100000/- at the end
of year. Suppose the rate of interest is 10% than you would
have to invest 100000/1.1=Rs 90909 This means that the
present value today of Rs 100000/- onward one year is Rs
90909/(NPV) or net present worth (NPW) is defined as the total
present value (PV) of a time series of cash flows. It is a
standard method for using the time value of money to
appraise long-term projects. Used for capital budgeting, and
widely throughout economics, it measures the excess or
shortfall of cash flows, in present value terms, once financing
charges are met.
According to last position today's worth of cash flow in future
was Rs 90900/- but it is not necessary that you may have
invested in some project Rs 90909/- today. It may be Rs
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75000/ therefore your net present value may be Rs15909 i.e.
NPV=PV-required investment or NPV= Co+C1/1+r i.e. -75000+
(100000/1.1) = Rs 15909
What NPV Means
If NPV > 0 the investment would add value to the firm the
project may be accepted. NPV < 0 the investment would
subtract value from the firm the project should be rejected.
NPV = 0 the investment would neither gain nor lose value for
the firm. However, NPV = 0 does not mean that a project is
only expected to break even, in the sense of undiscounted
profit or loss (earnings) it can show net total positive cash flow
and earnings over its life.
Market Equilibrium
General equilibrium theory is a branch of theoretical
neoclassical economics. It seeks to explain the behavior of
supply, demand and prices in a whole economy with several
or many markets, by seeking to prove that equilibrium prices
for goods exist and that all prices are at equilibrium, hence
general equilibrium, in contrast to partial equilibrium. As with
all models, this is an abstraction from a real economy, but is
proposed as being a useful model, both by considering
equilibrium prices as long-term prices, and by considering
actual prices as deviations from equilibrium.
General equilibrium theory both studies economies using the
model of equilibrium pricing, and seeks to determine in which
circumstances the assumptions of general equilibrium will
hold. The theory dates to the 1870s, particularly the work of
French economist Léon Walras.
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In economics, economic equilibrium is simply a state of the
world where economic forces are balanced and in the absence
of external influences the (equilibrium) values of economic
variables will not change. It is the point at which quantity
demanded and quantities supplied are equal. Market
equilibrium, for example, refers to a condition where a
market price is established through competition such that the
amount of goods or services sought by buyers is equal to the
amount of goods or services produced by sellers. This price is
often called the equilibrium price or market clearing price and
will tend not to change unless demand or supply change.
Properties of Market equilibrium
When the price is above the equilibrium point there is a
surplus of supply; where the price is below the equilibrium
point there is a shortage in supply. Different supply curves and
different demand curves have different points of economic
equilibrium. In most simple microeconomic stories of supply
and demand in a market a static equilibrium is observed in a
market; however, economic equilibrium can exist in nonmarket relationships and can be dynamic. Equilibrium may
also be multi-market or general, as opposed to the partial
equilibrium of a single market.
As in most usage (say, that of chemistry), in economics
equilibrium means "balance," here between supply forces and
demand forces: for example, an increase in supply will disrupt
the equilibrium, leading to lower prices. Eventually, a new
equilibrium will be attained in most markets. Then, there will
be no change in price or the amount of output bought and
sold — until there is an exogenous shift in supply or demand
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(such as changes in technology or tastes). That is, there are no
endogenous forces leading to the price or the quantity.
Not all economic equilibria are stable. For an equilibrium to be
stable, a small deviation from equilibrium leads to economic
forces that returns an economic sub-system toward the
original equilibrium. For example, if a movement out of
supply/demand equilibrium leads to an excess supply (glut)
that induces price declines which return the market to a
situation where the quantity demanded equals the quantity
supplied. If supply and demand curves intersect more than
once, then both stable and unstable equilibria are found.
Graphical presentation of equilibrium
•
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Words used in the slide
•
P – price, Q - quantity of good, S – supply.,D – demand,
P0 - price of market balance A - surplus of demand when P<P0, B - surplus of supply - when P>P0
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Chapter 6
Macroeconomics/Development
Economics/International Economics
Macroeconomics (from prefix "macro(o)-" meaning "large" +
"economics") is a branch of economics that deals with the
performance, structure, and behavior of the economy of the
entire community, either a nation, a region, or the entire
world. Along with microeconomics, macroeconomics is one of
the two most general fields in economics. It is the study of all
the aspects, mainly the behavior and decision-making, of
entire economies.Macroeconomists study aggregated
indicators such as GDP, unemployment rates, and price indices
to understand how the whole economy functions.
Macroeconomists develop models that explain the
relationship between such factors as national income, output,
consumption, unemployment, inflation, savings, investment,
international trade and international finance. In contrast,
microeconomics is primarily focused on the actions of
individual agents, such as firms and consumers, and how their
behavior determines prices and quantities in specific markets.
While macroeconomics is a broad field of study, there are two
areas of research that are emblematic of the discipline: the
attempt to understand the causes and consequences of shortrun fluctuations in national income (the business cycle), and
the attempt to understand the determinants of long-run
economic growth (increases in national income).
Macroeconomic models and their forecasts are used by both
governments and large corporations to assist in the
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development and evaluation of economic policy and business
strategy
The gross domestic product (GDP) or gross domestic income
(GDI) is a basic measure of a country's overall economic
output. It is the market value of all final goods and services
made within the borders of a country in a year. It is often
positively correlated with the standard of living, though its use
as a stand-in for measuring the standard of living has come
under increasing criticism and many countries are actively
exploring alternative measures to GDP for that purpose
GDP = C + Inv + G + (eX – iM)
Where C is private consumption, Inv is gross investment, G is
government spending and eX and iM is export and import
Unemployment rate
It is in % and is = Unemployed workers/ Total Labor force
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Price Index
A price index (plural: “price indices” or “price indexes”) is a
normalized average (typically a weighted average) of prices for
a given class of goods or services in a given region, during a
given interval of time. It is a statistic designed to help to
compare how these prices, taken as a whole, differ between
time periods or geographical locations. In Pakistan they exist
in form of CPI, WPI and SPI representing consumer price index
reflecting prices of 350 items. The basket is constituted of 42%
from food items and 21% from house rent and construction
items. CPI or headline inflation are disclosed on monthly basis.
WPI and SPI are wholesale price index representing 37-50
items and Sensitive price indicators of 57 essential items. They
are disclosed on weekly basis by the Beauru of Statistics
Government of Pakistan
Fiscal policy
In economics, fiscal policy is the use of government spending
and revenue collection to influence the economy.
Fiscal policy can be contrasted with the other main type of
economic policy, monetary policy, which attempts to stabilize
the economy by controlling interest rates and the supply of
money. The two main instruments of fiscal policy are
government spending and taxation. Changes in the level and
composition of taxation and government spending can impact
on the following variables in the economy:
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
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The distribution of income.
Monetary poicy
Monetary policy is the process a government, central bank, or
monetary authority of a country uses to control (i) the supply
of money, (ii) availability of money, and (iii) cost of money or
rate of interest to attain a set of objectives oriented towards
the growth and stability of the economy . Monetary theory
provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary
policy, or a contractionary policy, where an expansionary
policy increases the total supply of money in the economy,
and a contractionary policy decreases the total money supply.
Expansionary policy is traditionally used to combat
unemployment in a recession by lowering interest rates, while
contractionary policy involves raising interest rates to combat
inflation. Monetary policy is contrasted with fiscal policy,
which refers to government borrowing, spending and taxation
Philips Curve
William Phillips, a New Zealand born economist, wrote a paper
in 1958 titled The Relationship between Unemployment and
the Rate of Change of Money Wages in the United Kingdom
1861–1957, which was published in the quarterly journal
Economica. In the paper Phillips describes how he observed an
inverse relationship between money wage changes and
unemployment in the British economy over the period
examined. Similar patterns were found in other countries and
in 1960 Paul Samuelson and Robert Solow took Phillips' work
and made explicit the link between inflation and
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unemployment: when inflation was high, unemployment was
low, and vice-versa
The Phillips curve in economics is hence a historical inverse
relationship between the rate of unemployment and the rate
of inflation in an economy. Stated simply, the lower the
unemployment in an economy, the higher the rate of increase
in nominal wages. While it has been observed that there is a
stable short run tradeoff between unemployment and
inflation that has not been observed in the long run.
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Monetary policy objectives
Monetary Policy:
Target Market
Variable:
Long Term
Objective:
Inflation Targeting
Interest rate on overnight A given rate of
debt
change in the CPI
Price Level
Targeting
Interest rate on overnight A specific CPI
debt
number
Monetary
Aggregates
The growth in money
supply
A given rate of
change in the CPI
Fixed Exchange
Rate
The spot price of the
currency
The spot price of
the currency
Gold Standard
The spot price of gold
Low inflation as
measured by the
gold price
Mixed Policy
Usually interest rates
Usually
unemployment +
CPI change
Development economics
Development economics is a branch of economics which deals
with economic aspects of the development process in lowincome countries. Its focus is not only on methods of
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promoting economic growth and structural change but also on
improving the potential for the mass of the population, for
example, through health and education and workplace
conditions, whether through public or private channels.
Development economics involves the creation of theories and
methods that aid in the determination of policies and
practices and can be implemented at either the domestic or
international level. This may involve restructuring market
incentives or using mathematical methods like inter-temporal
optimization for project analysis, or it may involve a mixture of
quantitative and qualitative methods. Unlike in many other
fields of economics, approaches in development economics
may incorporate social and political factors to devise
particular plans. Also unlike many other fields of economics,
there is "no consensus" on what students should know.
Different approaches may consider the factors that contribute
to economic convergence or non-convergence across
households, regions, and countries.
Developing countries
Developing country is a term generally used to describe a
nation with a low level of material well being. There is no
single internationally-recognized definition of developed
country, and the levels of development may vary widely
within so-called developing countries, with some developing
countries having high average standards of living.
Some international organizations like the World Bank use
strictly numerical classifications. The World Bank considers all
low- and middle- income countries as "developing". In its most
recent classification, economies are divided using 2008 Gross
National Income per capita. In 2008, countries with GNI per
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capita below US$11,905 were considered developing. Other
institutions use less specific definitions.
Countries with more advanced economies than other
developing nations, but which have not yet fully
demonstrated the signs of a developed country, are grouped
under the term newly industrialized countries
Economic growth
Economic growth is a term used to indicate the increase of per
capita gross domestic product (GDP) or other measure of
aggregate income. It is often measured as the rate of change
in GDP. Economic growth refers only to the quantity of goods
and services produced.
Economic growth can be either positive or negative. Negative
growth can be referred to by saying that the economy is
shrinking. Negative growth is associated with economic
recession and economic depression.
In order to compare per capita income across multiple
countries, the statistics may be quoted in a single currency,
based on either prevailing exchange rates or purchasing
power parity. To compensate for changes in the value of
money (inflation or deflation) the GDP or GNP is usually given
in "real" or inflation adjusted, terms rather than the actual
money figure compiled in a given year, which is called the
nominal or current figure
Structural change
Structural change of an economy refers to a long-term
widespread change of the fundamental structure, rather than
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micro scale or short-term output and employment. For
example, a subsistence economy is transformed into a
manufacturing economy, or a regulated mixed economy is
liberalized. A current structural change in the world economy
is globalization.
Fisher (1939) and Clark (1940) look at patterns in changes in
sectoral employment. The logic of their arguments being that
patterns of production are functions of the level of income
and that resource and production shifts are an integral part of
development. The major determinant of these shifts is the
income elasticity of demand. Goods or sectors for which there
is a high income elasticity of demand will grow in importance
as income grows. Countries start with their production
dominated by primary production, then secondary activities
start to dominate and finally the tertiary sector dominates.
Structural change can be initiated by policy decisions or
permanent changes in resources, population or the society.
The downfall of communism, for example, is a political change
that has had far-reaching implications on the economies
dependent on the state-run Soviet economy. Structural
change involves obsolescence of skills, vocations, and
permanent changes in spending and production resulting in
structural unemployment.
Short-term economical challenges can be managed with shortterm fiscal or monetary policy decisions, and fluctuations are
expected to even out in a few years. Managing structural
change requires long-term investments such as education, and
reforms aimed at increasing labor mobility. The Trade
Adjustment Assistance is an example of such a program
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Per capita Gross Domestic Product (GDP per head) is used by
many developmental economists as an approximation of
general national well-being. However, these measures are
criticized as not measuring economic growth well enough,
especially in countries where there is much economic activity
that is not part of measured financial transactions (such as
housekeeping and self-homebuilding), or where funding is not
available for accurate measurements to be made publicly
available for other economists to use in their studies
(including private and institutional fraud, in some countries).
Even though per-capita GDP as measured can make economic
well-being appear smaller than it really is in some developing
countries, the discrepancy could be still bigger in a developed
country where people may perform outside of financial
transactions an even higher-value service than housekeeping
or homebuilding as gifts or in their own households, such as
counseling, lifestyle coaching, a more valuable home décor
service, and time management. Even free choice can be
considered to add value to lifestyles without necessarily
increasing the financial transaction amounts. More recent
theories of Human Development have begun to see beyond
purely financial measures of development, for example with
measures such as medical care available, education, equality,
and political freedom. Actual knowledge about what creates
growth is largely unproven; however recent advances in
econometrics and more accurate measurements in many
countries is creating new knowledge by compensating for the
effects of variables to determine probable causes out of
merely correlation statistics.
The most prominent contemporary development economist is
perhaps the Nobel laureate Amartya Sen. Recent theories
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revolve around questions about what variables or inputs
correlate or affect economic growth the most: elementary,
secondary, or higher education, government policy stability,
tariffs and subsidies, fair court systems, available
infrastructure, availability of medical care, prenatal care and
clean water, ease of entry and exit into trade, and equality of
income distribution and how to advise governments about
macroeconomic policies, which include all policies that affect
the economy. Education enables countries to adapt the latest
technology and creates an environment for new innovations.
The cause of limited growth and divergence in economic
growth lies in the high rate of acceleration of technological
change by a small number of developed countries. These
countries’ acceleration of technology was due to increased
incentive structures for mass education which in turn created
a framework for the population to create and adapt new
innovations and methods. Furthermore, the content of their
education was composed of secular schooling that resulted in
higher productivity levels and modern economic growth.
International economics
International economics is concerned with the effects upon
economic activity of international differences in productive
resources and consumer preferences and the institutions that
affect them. It seeks to explain the patterns and consequences
of transactions and interactions between the inhabitants of
different countries, including trade, investment and migration.
International trade studies goods-and-services flows across
international boundaries from supply-and-demand factors,
economic integration, and policy variables such as tariff rates
and trade quotas.
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International finance studies the flow of capital across
international financial markets, and the effects of these
movements on exchange rates.
International monetary economics and macroeconomics
studies money and macro flows across countries
Economic integration
Economic integration refers to trade unification between
different states by the partial or full abolishing of customs
tariffs on trade taking place within the borders of each state.
This is meant in turn to lead to lower prices for distributors
and consumers (as no customs duties are paid within the
integrated area) and the goal is to increase trade. The trade
stimulation effects intended by means of economic
integration are part of the contemporary economic Theory of
the Second Best: where, in theory, the best option is free
trade, with free competition and no trade barriers
whatsoever. Free trade is treated as an idealistic option, and
although realized within certain developed states, economic
integration has been thought of as the "second best" option
for global trade where barriers to full free trade exist.
An increase of welfare has been recognized as a main
objective of economic integration. The increase of trade
between member states of economic unions is meant to lead
to the increase of the GDP of its members, and hence, to
better welfare - a goal of any state around the world. This is
one of the reasons for the global scale development of
economic integration, a phenomenon now realized in
continental (ASEAN, NAFTA, SACN, EU, EurAsEC) and proposed
for intercontinental (CEPEA, TAFTA) economic blocks. The
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other objective for the states pursuing economic integration is
to stay / become regionally and globally competitive, as the
goods in the states outside economic blocks become more
expensive (i.e. less competitive). This is the other reason
making global economic integration inevitable.
Capitalism
Capitalism is an economic and social system in which capital,
the non-labor factors of production (also known as the means
of production), is privately owned; labor, goods and capital are
traded in markets; and profits distributed to owners or
invested in technologies and industries.
There is no consensus on the definition of capitalism, nor how
it should be used as an analytical category. There are a variety
of historical cases over which it is applied, varying in time,
geography, politics and culture. Economists, political
economists and historians have taken different perspectives
on the analysis of capitalism. Scholars in the social sciences,
including historians, economic sociologists, economists,
anthropologists and philosophers have debated over how to
define capitalism; however there is little controversy that
private ownership of the means of production, creation of
goods or services for profit in a market, and prices and wages
are elements of capitalism.
Economists usually put emphasis on the market medievalism,
degree of government does not have control over markets
(laissez faire), and property rights, while most political
economists emphasize private property, power relations,
wage labor, and class. There is a general agreement that
capitalism encourages economic growth. The extent, to which
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different markets are "free", as well as the rules determining
what may and may not be private property, is a matter of
politics and policy and many states have what are termed
"mixed economies."
Capitalism as a system developed incrementally from the 16th
century in Europe, although capitalist-like organizations
existed in the ancient world, and early aspects of merchant
capitalism flourished during the Late Middle Ages. Capitalism
became dominant in the Western world following the demise
of feudalism. Capitalism gradually spread throughout Europe,
and in the 19th and 20th centuries, it provided the main
means of industrialization throughout much of the world.
Islamic Capitalism
The origins of capitalism and free markets can be traced back
to the Islamic Golden Age and Muslim Agricultural Revolution,
where the first market economy and earliest forms of
merchant capitalism took root between the eighth–twelfth
centuries, which some refer to as "Islamic capitalism". A
vigorous monetary economy was created by Muslims on the
basis of the expanding levels of circulation of a stable highvalue currency (the dinar) and the integration of monetary
areas that were previously independent. Innovative new
business techniques and forms of business organization were
introduced by economists, merchants and traders during this
time. Such innovations included the earliest trading
companies, big businesses, contracts, bills of exchange, longdistance international trade, the first forms of partnership
(mufawada) such as limited partnerships (mudaraba), and the
earliest forms of credit, debt, profit, loss, capital (al-mal),
capital accumulation (nama al-mal), circulating capital, capital
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expenditure, revenue, cheques, promissory notes,[35] trusts
(see Waqf), startup companies, savings accounts,
transactional accounts, pawning, loaning, exchange rates,
bankers, money changers, ledgers, deposits, assignments, the
double-entry
bookkeeping
system,
and
lawsuits.
Organizational
enterprises
similar
to
corporations
independent from the state also existed in the medieval
Islamic world, while the agency institution was also
introduced. Many of these early capitalist concepts were
adopted and further advanced in medieval Europe from the
13th century onwards
Mercantilism
The period between the sixteenth and eighteenth centuries is
commonly described as mercantilism. This period was
associated with geographic exploration of the Age of
Discovery being exploited by merchant overseas traders,
especially from England and the Low Countries; the European
colonization of the Americas; and the rapid growth in overseas
trade. Mercantilism was a system of trade for profit, although
commodities were still largely produced by non-capitalist
production methods.
While some scholars see mercantilism as the earliest stage of
modern capitalism, others argue that modern capitalism did
not emerge until later. For example, Karl Polanyi, noted that
"mercantilism, with all its tendency toward commercialization,
never attacked the safeguards which protected [the] two basic
elements of production—labor and land—from becoming the
elements of commerce"; thus mercantilist attitudes towards
economic regulation were closer to feudalist attitudes, "they
disagreed only on the methods of regulation."
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Moreover Polanyi argued that the hallmark of capitalism is the
establishment of generalized markets for what he referred to
as the "fictitious commodities": land, labor, and money.
Accordingly, "not until 1834 was a competitive labor market
established in England, hence industrial capitalism as a social
system cannot be said to have existed before that date."
Industrial Revolution
The Bank of England is one of the oldest central banks. It was
founded in 1694 and nationalised in 1946.
A new group of economic theorists, led by David Hume and
Adam Smith, in the mid 18th century, challenged fundamental
mercantilist doctrines as the belief that the amount of the
world’s wealth remained constant and that a state could only
increase its wealth at the expense of another state.
During the Industrial Revolution, the industrialist replaced the
merchant as a dominant actor in the capitalist system and
effected the decline of the traditional handicraft skills of
artisans, guilds, and journeymen. Also during this period, the
surplus generated by the rise of commercial agriculture
encouraged increased mechanization of agriculture. Industrial
capitalism marked the development of the factory system of
manufacturing, characterized by a complex division of labor
between and within work process and the routinization of
work tasks; and finally established the global domination of
the capitalist mode of production.
Monopolism
In the late 19th century, the control and direction of large
areas of industry came into the hands of trusts, financiers and
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holding companies. This period was dominated by an
increasing number of oligopolistic firms earning supernormal
profits. Major characteristics of capitalism in this period
included the establishment of large industrial cartels or
monopolies; the ownership and management of industry by
financiers divorced from the production process; and the
development of a complex system of banking, an equity
market, and corporate holdings of capital through stock
ownership. The petroleum, telecommunication, railroad,
shipping, banking and financial industries are characterized by
its monopolistic domination. Inside these corporations, a
division of labor separates shareholders, owners, managers,
and actual laborer
Keynesianism and neoliberalism
In the period following the global depression of the 1930s, the
state played an increasingly prominent role in the capitalistic
system throughout much of the world.
After World War II, a broad array of new analytical tools in the
social sciences were developed to explain the social and
economic trends of the period, including the concepts of postindustrial society and the welfare state. This era was greatly
influenced by Keynesian economic stabilization policies. The
postwar boom ended in the late 1960s and early 1970s, and
the situation was worsened by the rise of stagflation.
Exceptionally high inflation combined with slow output
growth, rising unemployment, and eventually recession to
cause a loss of credibility in the Keynesian welfare-statist
mode of regulation. Under the influence of Friedrich Hayek
and Milton Friedman, Western states embraced policy
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prescriptions inspired by laissez-faire capitalism and classical
liberalism.
In particular, monetarism, a theoretical alternative to
Keynesianism that is more compatible with laissez-faire,
gained increasing prominence in the capitalist world,
especially under the leadership of Ronald Reagan in the US
and Margaret Thatcher in the UK in the 1980s. Finally, the
general public's interest was shifted from the collectivist
concerns of Keynes's managed capitalism to a focus on
individual freedom and choice, called "remarketized
capitalism." In the eyes of many economic and political
commentators, the collapse of the Soviet Union brought
further evidence of the superiority of market capitalism over
communism.
Globalization
Although international trade has been associated with the
development of capitalism for over five hundred years, some
thinkers argue that a number of trends associated with
globalization have acted to increase the mobility of people
and capital since the last quarter of the 20th century,
combining to circumscribe the room to maneuver of states in
choosing non-capitalist models of development. Today, these
trends have bolstered the argument that capitalism should
now be viewed as a truly world system. However, other
thinkers argue that globalization, even in its quantitative
degree, is no greater now than during earlier periods of
capitalist trade.
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How capitalism works
Individuals: - Individuals engage in a capitalist economy as
consumers, laborers, and investors. For example, as
consumers, individuals influence production patterns through
their purchase decisions, as producers will change production
to produce what is most profitable (most often what
consumers want to buy).
Businesses:-Business firms decide what to produce and where
this production should occur. They also purchase inputs
(materials, labor, and capital). Businesses try to influence
consumer purchase decisions through marketing and
advertisement as well as the creation of new and improved
products. Driving the capitalist economy is the search for
profits (revenues minus expenses). This is known as the profit
motive, and it helps ensure that companies produce the goods
and services that consumers desire and are able to buy.
The market:-The price P of a product is determined by a
balance between production at each price (supply S) and the
desires of those with purchasing power at each price (demand
D). This result in market equilibrium, with a given quantity (Q)
sold of the product. A rise in demand from D1 to D2 would
result in an increase in price from P1 to P2 and an increase in
output from Q1 to Q2.
The market: - It is a term used by economists to describe a
central exchange through which people are able to buy and
sell goods and services. In a capitalist economy, the prices of
goods and services are controlled mainly through supply and
demand and competition.
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Income: - Income in a capitalist economy depends primarily on
what skills are in demand and what skills are currently being
supplied. People who have skills that are in scarce supply are
worth a lot more in the market and can attract higher
incomes. Competition among employers for workers and
among workers for jobs, help determine wage rates.
The government:- In capitalist nations, the government does
not prohibit private property, or prevent individuals from
working where they please. The government also does not
prevent firms from determining what wages they will pay and
what prices they will charge for their products.
Marxist political economy
Karl Marx considered capitalism to be a historically specific
mode of production (the way in which the productive property
is owned and controlled, combined with the corresponding
social relations between individuals based on their connection
with the process of production) in which capitalism has
become the dominant mode of production.
The capitalist stage of development or "bourgeois society," for
Marx, represented the most advanced form of social
organization to date, but he also thought that the working
classes would come to power in a worldwide socialist or
communist transformation of human society as the end of the
series of first aristocratic, then capitalist, and finally working
class rule was reached.
Following Adam Smith, Marx distinguished the use value of
commodities from their exchange value in the market. Capital,
according to Marx, is created with the purchase of
commodities for the purpose of creating new commodities
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with an exchange value higher than the sum of the original
purchases. For Marx, the use of labor power had itself become
a commodity under capitalism; the exchange value of labor
power, as reflected in the wage, is less than the value it
produces for the capitalist.
This difference in values, he argues, constitutes surplus value,
which the capitalists extract and accumulate. In his book
Capital, Marx argues that the capitalist mode of production is
distinguished by how the owners of capital extract this surplus
from workers—all prior class societies had extracted surplus
labor, but capitalism was new in doing so via the sale-value of
produced commodities. He argues that a core requirement of
a capitalist society is that a large portion of the population
must not possess sources of self-sustenance that would allow
them to be independent, and must instead be compelled, to
survive, to sell their labor for a living wage.
In conjunction with his criticism of capitalism was Marx's
belief that exploited labor would be the driving force behind a
revolution to a socialist-style economy. For Marx, this cycle of
the extraction of the surplus value by the owners of capital or
the bourgeoisie becomes the basis of class struggle. This
argument is intertwined with Marx's version of the labor
theory of value asserting that labor is the source of all value,
and thus of profit.
Vladimir Lenin, in Imperialism, the Highest Stage of Capitalism
(1916), modified classic Marxist theory and argued that
capitalism necessarily induced monopoly capitalism—which
he also called "imperialism"—to find new markets and
resources, representing the last and highest stage of
capitalism. Some 20th century Marxian economists consider
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capitalism to be a social formation where capitalist class
processes dominate, but are not exclusive.
Capitalist class processes, to these thinkers, are simply those
in which surplus labor takes the form of surplus value, usable
as capital; other tendencies for utilization of labor nonetheless
exist simultaneously in existing societies where capitalist
processes are predominant. However, other late Marxian
thinkers argue that a social formation as a whole may be
classed as capitalist if capitalism is the mode by which a
surplus is extracted, even if this surplus is not produced by
capitalist activity, as when an absolute majority of the
population is engaged in non-capitalist economic activity.
Socialism refers to the various theories of economic
organization advocating common or direct worker ownership
and administration of the means of production and allocation
of resources, and a society characterized by equal access to
resources for all individuals with a method of compensation
based on the amount of labor expended.
Most socialists share the view that capitalism unfairly
concentrates power and wealth among a small segment of
society that controls capital and derives its wealth through
exploitation, creates an unequal society, does not provide
equal opportunities for everyone to maximize their potential
and does not utilize technology and resources to their
maximum potential nor in the interests of the public.
Modern socialism originated in the late 18th-century
intellectual and working class political movement that
criticized the effects of industrialization and private ownership
on society. The utopian socialists, including Robert Owen
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(1771–1858), tried to found self-sustaining communes by
secession from a capitalist society. Henri de Saint Simon
(1760–1825), the first individual to coin the term socialism,
was the original thinker who advocated technocracy and
industrial planning. The first socialists predicted a world
improved by harnessing technology and combining it with
better social organization, and many contemporary socialists
share this same belief. Early socialist thinkers tended to favor
an authentic meritocracy combined with rational social
planning, while many modern socialists have a more
egalitarian approach.
Vladimir Lenin, drawing on Karl Marx's ideas of "lower" and
"upper" stages of socialism defined socialism as a transitional
stage between capitalism and communism.
Socialism in the 21st century
Those who championed socialism in its various Marxist and
class struggle forms sought out other arenas than the parties
of social democracy at the turn of the 21st century. Anticapitalism and globalization movements rose to prominence
particularly through events such as the opposition to the WTO
meeting of 1999 in Seattle. Socialist-inspired groups played an
important role in these new movements, which nevertheless
embraced much broader layers of the population, and were
championed by figures such as Noam Chomsky. The 2003
invasion of Iraq led to a significant anti-war movement in
which socialists argued their case.
The Financial crisis of 2007–2010 led to mainstream
discussions as to whether "Marx was right". Time magazine
ran an article 'Rethinking Marx' and put Karl Marx on the
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cover of its European edition in a special for the 28 January
2009 Davos meeting. While the mainstream media tended to
conclude that Marx was wrong, this was not the view of
socialists and left-leaning commentators.
A Global BBC poll on the twentieth anniversary of the fall of
the Berlin Wall found that 23% of respondents believe
capitalism is "fatally flawed and a different economic system is
needed", with that figure rising to 40% of the population in
some developed countries such as France; while a majority of
respondents including over 50% of Americans believe
capitalism "has problems that can be addressed through
regulation and reform". Opinions regarding the demise of the
Soviet Union are also heavily divided between the developed
and developing world, with the latter believing the
disintegration of the Soviet Union was a bad thing.
Mixed economy
A mixed economy is an economic system that includes a
variety of public and government control, or a mixture of
capitalism and socialism.
There is not one single definition for a mixed economy, but
relevant aspects include: a degree of private economic
freedom (including privately owned industry) intermingled
with centralized economic planning and government
regulation (which may include regulation of the market for
environmental concerns, social welfare or efficiency, or state
ownership and management of some of the means of
production for national or social objectives).
For some states, there is not a consensus on whether they are
capitalist, socialist, or mixed economies. Economies ranging
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from the United States to Cuba have been termed mixed
economies.
The mixed economy as an economic ideal is supported by
social democrats as a compromise between socialism and
free-market capitalism, among others.
Islamic Economics
Islamic economics means economics in accordance with
Islamic law. Islamic economics can refer to the application of
Islamic law to economic activity either where Islamic rule is in
force or where it is not; i.e. it can refer to the creation of an
Islamic economic system, or to simply following Islamic law in
regards to spending, saving, investing, giving, etc. where the
state does not follow Islamic law.
The former paradigm, particularly as developed by modern
scholars such as Mahmoud Taleghani, and Mohammad Baqir
al-Sadr, seeks not only to enforce Islamic regulations on issues
such as Zakat, Jizya, Nisab, Khums, Riba, insurance and
inheritance, but to implement broader economic goals and
policies of an Islamic society. It seeks an economic system
based on uplifting the deprived masses, a major role for the
state in matters such as circulation and equitable distribution
of wealth and ensuring participants in the marketplace are
rewarded for being exposed to risk and/or liability. Islamists
movements and authors will generally describe this system as
being neither Socialist nor Capitalist, but a third way with
none of the drawbacks of the other two systems.
The latter paradigm is of necessity more limited, revolving
around a few main tenets of Islam: the payment of zakat
charity by believers, borrowing and lending without payment
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of fixed interest (riba), and socially responsible investing. The
key difference from a financial perspective is the no-interest
rule since most other religions favor charitable giving and
socially responsible investing.
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Chapter 7
Defining Islamic Economics
As already stated Economics is the social science that studies the
production, distribution and consumption of goods and services. The
term economics comes from the Ancient Greek ojkovouia
(oikonomia, "management of a household, administration).
A definition that captures much of modern economics is that of
Lionel Robbins in a 1932 essay: "the science which studies human
behavior as a relationship between ends and scarce means which
have alternative uses."
However apart from above definitions, Islamic economics, which got
due attention onward 1976 meeting in Makah of Islamic scholars, is
now in process of its refinement.
Before that we find a definition formulated by the Persian Muslim
scholars Nasir al Din al Tusi (1201-1274). He defined it as “the study
of universal laws governing the public interest (welfare) in so far as
they are directed, through cooperation, toward the optimal
(perfection)”.
Later, onward 1976, Mannan defines Islamic Economics as a “Social
Science which studies the economic problems of people imbued with
the values of Islam”.
According to Hasanuz Zaman “Islamic Economics is the knowledge
and application of its functions and rules of Shariah that prevent
injustice in the acquisition and disposal of material resources in order
to provide satisfaction to human beings and enable them to perform
their obligations to Allah and the society”.
Economist, Akram says that, “Islamic Economics, aims at the study
of human falah achieved by organizing the resources of earth on the
basis of cooperation and participation”.
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Another economist Arif notes that “Islamic Economics is the study
of behavior of a human society that organizes the resources in form
of a trust to achieve falah”.
Above looking, Tusis definition looks wider and universal to those
definitions that came onward in the current years.
In fact now a consensus is emerging that Islamic economics is a
combination of normative (How to), non-economic (social and
welfare), and al-Akhira (Hereafter) factors into the subject matter.
Further the direction of Islamic economics is set towards well being
of humankind and not confined to match only scarce resources with
unlimited needs.
We read in the Quran that:
•
•
[Eat and drink of that which God has provided and act not
corruptly, making mischief in the world] (Al-Baqarah 2:60).
[O you who believe! Forbid not the good things which God
has made lawful for you and exceed not the limits. Surely,
God loves not those who exceed the limits. And eat of the
lawful and good that God has given you, and keep your duty
to God in whom you believe] (Al-Ma'idah 5:87-88).
These verses of the Quran, and there are many others like these,
strike the keynote of the Quranic message in the economic field.
Islam urges Muslims and others to enjoy the bounties provided by
God.
It even equates the struggle for material well-being with an act of
virtue.
•
[When the prayer is ended, then disperse in the land and seek
of God’s bounty] (Al-Jumu`ah 62:10).
The Prophet Muhammad has also said:
•
"If God provides anyone of you with an opportunity for
earning livelihood, let him not leave it unexploited until it is
exhausted or becomes disagreeable to him." (Ibn Majah)
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"Any Muslim who plants a tree or cultivates a field such that
a bird, or a human being, or an animal eats from it, this act
will be counted as an act of charity." (Al-Bukhari)
Islam goes even further than this. It urges Muslims and others to gain
mastery over nature because, according to the Quran, all resources in
the heavens and the earth have been created for the service of
mankind. (Luqman 31:20)
From this, one cannot but infer that the goal of attaining a suitably
high rate of economic growth should be among the economic goals
of a Muslim or any society.
This would be the manifestation of a continuous effort to use,
through research and improvements in technology, the resources
provided by God for the service and betterment of mankind, thus
helping in the fulfillment of the very object of their creation.
We read in the Quran the following verses:
•
•
[O mankind! There has come to you indeed an admonition
from your Lord, and a healing for what is in your hearts, and
for those who believe a guidance and a blessing] (Yunus
10:57).
[God desires ease for you and desires not hardship for you]
(Al-Baqarah 2:185).
On the basis of these verses of the Quran, Muslim jurists have
unanimously held that catering for the interests of the people and
relieving them of hardships is the basic objective of the Islamic
jurisprudence.
In regard to Islamic economics one can divide its supporters in to
two groups. One considers it as an offshoot of conventional
economics and the other group considers it as a separate discipline.
Laliwala, Haq, and Siddiqui are the main exponents of first
viewpoint. Mannan, Khurshid, Hasanuz Zaman, Akram Khan and
Arif are the supporters of second view point. In all respect the second
group has well founded grounds as the parameters of Islamic
economics are somewhat different from conventional economics.
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However going forward in becoming model for the whole world it
would tend to remain and would interact within the periphery of
general economics for all practical purposes.
After recent worldwide recession, era of political economy (Adam
Smith, Ricardo, Malthus), forgotten long ago has now again become
a matter of debate mainly due to its emphasis on the question of
value in an economy. Second question taking the front seat is that
how states can play their due role more proactively in the welfare of
mankind. So to some extent conventional economics is converging
towards Islamic economics on the question of welfare of mankind.
Now in case of Islamic economics, it is distinctly separate from the
conventional economics in the following terms.
1. Economic activity has to be carried out by distinguishing
haram and halal as has been defined clearly for
commodities as well as for financial market transactions.
This tends to affect demand and supply curve and consumer
behavior at its equilibrium point. In financial market
transaction, it has to be Riba free and without speculation.
In end result the financial market structure under Islamic
economics works under positive sum game and not under
zero sum game that means any ones gain is every ones gain
and any ones loss is any ones loss. Key word in Islamic
economics is cooperation.
2. The land and its resources do not belong to any private
hand/entity, however any thing earned through legitimate
labor becomes the private property of that earning hand.
This automatically puts a limit on endless holdings that one
sees normally.
3. Economic activity has to be planned in accordance with
Production Frontier Curve meaning that only desired and
needful products and not the lavished ones are to be
produced for their consumption.
4. Economic activities have to be carried out through some
business activities meaning that monetization can be done
only to the extent of essential capital formation. This puts a
brake on inflationary pressures. Further it makes
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government borrowing very difficult as each government
has limited assets against which it can borrow through
Islamic mode of financing.
5. Government is responsible for the well being of its people
especially for the economic needs of its down trodden class.
6. The business activities can not be contained under
monopoly or oligopoly pressures. For these, governments
are required to make certain arrangements. Already this
rule is being followed all over the world. In Pakistan we
have monopoly commission for this purpose.
These are some of the features of Islamic economics that encourages
mankind and societies not only to play their due role in the economic
welfare of the general people but to emphasize on economic growth
without creating undue inflationary pressures.
Now looking back in to the Islamic history some people believe that
system being followed during Khulfai Rashedeen or in some Islamic
rulers in the subsequent periods can be copy pasted.
In this regard one has to realize that as guiding principles those
periods are a model for us and they would remain so in the time to
come. However since the production activities have advanced a lot as
compared to those periods and further States have now enormous
welfare activities to undertake, so practically speaking we have to
find advanced models for moving forward in line with principles set
in the life of Hazrat Muhammad (PBU) or during Khulfai
Rasheeden.
For example during Hazrat Umar (RU), the system of taxation was at
infancy. The Baitul Mal used to receive its revenue through Zakat,
Kharag, Khum, Jaziah and likewise subjects. Further on expenditure
side the State was not responsible to pay on its forces or to expend
on public welfare activities in highly organized manner. The forces
were raised as and when needed and they used to get their
remuneration mainly from Male-Ghanimat. Likewise people used to
fulfill their social responsibilities through cooperation. These models
suited that time period and obviously they were a step ahead from
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their previous systems. Islam came at the start of feudal era and
played its role in winding up of slave era. Later advances it made on
the economic front is now named as Islamic Capitalism that was a
combination of cross border trading and feudal activities. In 1500
onward, mercantilism took its birth in Europe that turned in to
Industrial revolution and ultimately in to capitalism and imperialism
(the worst form of capitalism).
Re-emergence of Islamic economics now is a positive development
not from Islamic angle but from the global perspective. In Islamic
and conventional economics there are consensuses on various points.
Like, securitization is close to fund raising mechanism in the Islamic
Finance. However since this kind of financing (mortgage financing)
has become one of the reason for the current recession, so there is a
need to bring it more close to Islamic fund raising mechanism. In
infrastructure financing this dialogue has already started. Secondly,
current US Fed Governor Bernanke is in favor of hypotheses
forwarded by the scientists of political economy. He differs with
Keynes hypothesis that 1930 depression was caused due to lack of
investment. He supports that reason for that was the lack of liquidity
that mainly came due to mismanagement of the government or the
regulator. However on the point of intervention he agrees with
Keynes that it is the King (State or Regulator) who has to intervene.
Hence he is in favor of strengthening market mechanism with the
support of government or regulator. So the idea of combining
government with market forces is close to what Islamic economics
desire. Here market forces would have free access to market
resources with some limitations but final arbitration and monitoring
would come from the government or regulator. No doubt by making
every transaction in the market, based on some tangible asset, the
system would become less prone to the cycles of recession and
inflation on their extreme sides.
Lastly by looking in to the synthesis of Islamic Economics a
definition for Islamic economics is proposed as “the social science
that studies the dynamics of production, consumption and
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distribution of economic resources so as to optimize better life and
wellbeing of mankind on equitable basis”.
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Chapter 8
Evolution of Islamic Economic
thoughts
In today’s world the Islamic economics has gained an importance,
so to find out its utility, one has to go in to phases of its
development.
First lesson in this regard is that Islamic economics has come in to
being as a matter of continuity. One must remember saying of
Quran that “nothing has been said to you (Muhammad PBUH) that
was not said to the messengers before you (Al Quran, 41:43)
Though Islamic economics is different in some of its dimensions
from its conventional counterpart but its emergence and further
growth has also come in the same ways as of conventional i.e. with
the changes going on, in the society on account of changes in its
mode of production.
Islam came at the juncture when slave era was ending and Feudal
economy was taking its roots. This gave birth to Islamic capitalism
during 700-1500 AD. Onward, came the period of mercantilism in
Europe i.e. close to Feudal economy that turned in to political
economy (Adam Smith, Ricardo and Malthus) in 1700. It must be
remembered that economic thoughts are always entrenched on
mode of production prevailing at that time. For example ideas given
in “Republic” by Plato may look very revolutionary and still holds
well in explaining democracy, but still in defining property rights at
that time it define slaves and women as part of property.
Islamic economic thoughts can be segregated in to period of Hazrat
Muhammad (PBUH) when directions were coming in directly
through Quran and Sunnah. Thereafter period of Khulfai Rashedeen
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starts that developed it further through consensus getting from the
people who remained companions of Hazrat Muhammad (PBUH).
This period was difficult as boundaries of Islamic empire was
spreading with immense pace and people of different race and
systems were becoming part of the empire. Thereafter period of
other Muslim rulers’ starts that can be explained under the
definition of Islamic capitalism. Finally, Islamic thoughts can be
categorized as its revival in 1970 onward when different Islamic
States started getting free from their imperialist occupants. This era
is still going on in search of finding economic solutions under Islamic
thoughts.
Just imagine sixth and seventh centuries when Islam came in to
being and took its roots. In that period imagine about Makah and
Medina. One can look in to these two cities as two jewels in the
waterless steppes and desert having close ties with nomads. The
nomads’ life revolved around camels with agriculture products like
dates and cereals. Makah at that time was regarded as a prosperous
city set amidst barren rocks but monopolizing the trade between
the Indian Ocean and Mediterranean. Though Makah was a suitable
centre for international trade but an additional factor helped it a lot
and that was the concept of al-haram i.e. Makah was a place where
men and women can come without fear of any hostility and
molestation. In Makah the commercial activities got its support
from institutions as well. A Senate was in Place in Makah before
Islam to collect levies from caravans. In Makah shops, books of
accounts were available to check all kind of transactions besides
weighing goods. Coins were not in abundance. Precious metals like
gold, silver and gold dust were used as per their weights as currency
of exchange. Makah was also a banking city and clearing house for
traders as through these arrangements they could pay amounts at
distant places or could get insurance to trade through dangerous
routes. However on the flip side speculation was rampant on the
rates of exchange. Further fictitious associations were there to
make wrong deals. In fact at that time on, one side were big
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financiers, rich bankers and on the other side existed petty traders,
brokers and shop keepers. In result of this change came in form of
Islam when ultimately Makah was conquered by Muslims. It must
be understood that Quran not only came in the period of desert and
nomadic life but also came under financial and commercial
sophistications as well. The prophetic life of Hazrat Muhammad
(PBUH) is spread over a period of twenty three years i.e. thirteen
years in Makah and ten years in Medina. Some of the verses of
Quran regarding bay (sale) and tigarat (trade) were revealed during
his period in Makah. The Makah Surahs testify to the fact that Islam
was favorably inclined towards promotion of trading and
commercial activities. For say in Surat al Quraish it was asked to
take journeys to the south (Yemen) in the winter and north in the
summer (Syria). This instigated trading activities for the whole years
that were very much required for the trading atmosphere in the
Makah. During the Medina period, the Quranic injunctions on
commercial transactions were extended and became more
sophisticated, especially after Muslims had become an ummah or
community. In Medina, Muslims came in contact with Jews and
other non Muslims. This necessitated them to come with several
regulations and commandments relating to their life style. Quranic
verse in this regard says that “spread over the globe and seek of the
bounty of God”. In Surahs during Medina certain restrictions also
came about like distinction between decent trading, especially by
mutual goodwill between the contracting parties which is lawful and
usury (Riba) which is unlawful. Not only this, Quran further goes by
saying that “O ye believe! Fear God and give up what remains of
your demand for usury”. Besides usury, Quran also prohibited
bribery, gambling, consuming other property unlawfully. However
trading was allowed as on this Quran Says “Those who devour usury
will not stand except as sands one whom the evil one by his touch
hath driven to madness. That is because they say “trade is like
usury” but God hath permitted trade and forbidden usury”. Bonner
a western writer maintains that Hazarat Muhammad (PBUH) also
helped poor traders by allowing them to tent in lieu of permanent
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buildings in the market of Medina by not charging any fees and
rents there against. So Islam supports trading activities in all respect
but with some restrictions like no speculation, no fraudulent act etc.
After Hazrat Muhammad (PBUH) these concepts, like others in
Islamic law, came from the Quranic verses, prescriptions,
anecdotes, examples, and words of Muhammad, all gathered
together and systematized by commentators according to an
inductive, casuistic method. Sometimes other sources such as al-urf,
(the custom), al-aql (reason)) or al-ijma (consensus of the jurists)
were employed.
Period of Khulfai Rashedeen comprising of Hazrat Abu Bakar (RA),
Hazrat Umar (RA), Hazrat Usman (RA) and Hazrat Ali (RA) extended
Islamic thoughts further on the basis of above mechanism. During
this period, Islamic empire expanded a lot. However during this
period lot of challenges also came in front due to transformation
required for ongoing developing ideas.
During Khulfai Rashedeen lot of reforms came in to being. Like
collection of Kharag from non Muslims and usher from Muslims
became systematic and their rates were made more rational. The
collections of these kinds of taxes were in vogue since Pharaohs of
Egypt and of Roman Empire. Agriculture was given due importance.
Hazrat Umar (RA) on one occasion gave orders that in regard to
lands in far flung areas, whoever would make the land cultivable,
the piece of that land would belong to him. Zakat collection was
also made comprehensive. Baitul Mal in formal shape came in to
being first time during Hazrat Umar period. During Khulfai
Rashedden, Public works department also came in to being meaning
that State started taking its welfare responsibilities. Particular
emphasis was given on building of irrigation system, buildings for
public use, educational institutions. More rights were given to the
slaves. System of keeping armed forces was changed and first time
remunerations for soldiers and officers were fixed. The salary of
armed forces at that time was in the range of 200-400 Dirhams per
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year. The remuneration as such was also available to people doing
educational work, other government officials and needy persons. So
in nutshell period of Khulfai Rashedeen was a period when public
finance was formalized and given some structure in order to
conform to welfare of the society.
In later period, one sees prominence of four schools of Islam that
has been named on the name of classical jurists who taught them.
They have now their followings in the given geographical locations.
Hanafi: - (Syria, Turkey, Pakistan, the Balkans, Central Asia, Indian
subcontinent, Iran, Afghanistan, China and Egypt)
Maliki: - (North Africa, the Muslim areas of West Africa and several
of the Arab States of the Persian Gulf)
Shafis:Arabia,Indonesia,Malaysia,Maldives,Egypt,Somalia,Djibouti,Eritrea,E
thiopia,Yemen and southern parts of India.
Hambali: - (Arabia)
These four schools share most of their rulings, but differ on the
particular hadiths they accept as authentic and the weight they give
to analogy or reason (qias) in deciding difficulties. This some time
creates difference in practical application of economic rulings.
Currently on such interpretations Iran, Malaysia and Pakistan
including GCC have different interpretations on Riba on its some
parts.
Now moving forward some of the ideas formulated by some of the
Muslim scholars during era of Islamic capitalism (700-1500 AD) and
of current period, they are as follows:Imam Abu Yusuf (731-738 AD):- He was disciple of Imam Abu
Hanifa and served as chief justice of Abbasside Sultanate. His main
contribution is on developing taxation system and on highlighting
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the economic responsibilities of an Islamic State. He was in favor of
proportional tax rate rather than fix levy on land. He also favored
idea of tax levying on the basis of capacity to pay tax, convenience
of assesses and of constituting a central tax administration. Further
Imam Abu Yusuf stressed upon the public welfare works especially
in providing irrigation, highway facilities and in development of
agriculture sector.
Abu 'Ubayd al-Qasim ibn Sallam (154-224 AH 770-838 AD), the son
of a Byzantine slave in Herat, forged a career for himself as a noted
scholar and jurist, even making the acquaintance of the 'Abbasid
caliph al-Ma'mun. Abu 'Ubayd also left behind several works on
aspects of law and language, one of which, the Kitab al-amwal
probably inspired in part by his two decades as a judge. He mainly
focused on fiscal system of Islam i.e. Rate and collection of Fay,
Khums, jazia, Kharaj, Zakat, custom duties. Hence he mainly focused
on revenue generation of an Islamic State, their distribution and of
making expenditure.
Ibn Khaldun (1332-1406 AD) is considered one of the fathers of
modern economics. He was North African by birth. He wrote on
economic and political theory in his book the Muqaddimah, relating
his thoughts on the division of labor i.e. the greater the social
cohesion, the more complex the division may be, the greater the
economic growth would be. He writes “When civilization
[population] increases, the available labor again increases. In turn,
luxury again increases in correspondence with the increasing profit,
and the customs and needs of luxury increase. Crafts are created to
obtain luxury products. The value realized from them increases,
and, as a result, profits are again multiplied in the town. Production
there is thriving even more than before. And so it goes with the
second and third increase. All the additional labor serves luxury and
wealth, in contrast to the original labor that served the necessity of
life”.
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Ibn Khaldun covered the topic of economic growth in more detail,
noting that growth and development positively stimulate both
supply and demand, and that the forces of supply and demand are
what determine the prices of goods. He also noted macroeconomic
forces of population growth, human capital development, and
technological developments effects on development. Ibn Khaldun
held that population growth was a function of wealth.
Ibn Khaldun understood that money served as a standard of value, a
medium of exchange, and a preserver of value, though he did not
realize that the values of gold and silver changes are based on the
forces of supply and demand. Ibn Khaldun also introduced the labor
theory of value. He described labor as the source of value,
necessary for all earnings and capital accumulation, obvious in the
case of craft. He argued that even if earning “results from
something other than a craft, the value of the resulting profit and
acquired (capital) must (also) include the value of the labor by
which it was obtained. Without labor, it would not have been
acquired”.
His theory of asabiyyah has often been compared to modern
Keynesian economics, with Ibn Khaldun's theory clearly containing
the concept of the multiplier. A crucial difference, however, is that
whereas for John Maynard Keynes, it is the middle class’s greater
propensity to save that is to blame for economic depression, for Ibn
Khaldun it is the governmental propensity to save at times when
investment opportunities do not take up the slack which leads to
aggregate demand.
Another modern economic theory anticipated by Ibn Khaldun is
supply side economics He argued that high taxes were often a factor
in causing empires to collapse, with the result that lower revenue
was collected from high rates. He wrote:-
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"It should be known that at the beginning of the dynasty, taxation
yields large revenue from small assessments. At the end of the
dynasty, taxation yields small revenue from large assessments.”
Ibn Khaldun introduced the concept popularly known as the Laffer
curve that increase in tax rates initially increase tax revenues, but
eventually increase in tax rates cause a decrease in tax revenues.
This occurs as too high a tax rate discourages producers in the
economy.
Ibn Khaldun used a dialect approach to describe the sociological
implications of tax choice (which now forms a part of economic
theory).
“In the early stages of the state, taxes are light in their incidence,
but fetch in large revenue...As time passes and kings succeed each
other, they lose their tribal habits in favor of more civilized ones.
Their needs and exigencies grow...owing to the luxury in which they
have been brought up. Hence they impose fresh taxes on their
subjects...and sharply raise the rate of old taxes to increase their
yield...But the effects on business of this rise in taxation make
themselves felt. For business men are soon discouraged by the
comparison of their profits with the burden of their
taxes...Consequently production falls off, and with it the yield of
taxation”
This analysis is very similar to the modern economic concept known
as the Laffer curve.
Taqi ad-Din Ahmad ibn Taymiyyah (January 22, 1263 – 1328), was a
famous Muslim scholar born in Harran, located in what is now
Turkey, close to the Syrian border. He lived during the troubled
times of the Mongol invasions. As a member of the school founded
by Ibn Hambal, he sought the return of Islam to its sources, the
Quran and the Sunnah. His notion of the price of the equivalent and
the complementary concept of fair profit are very important. He
wanted to investigate what the price would be if there were no
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imperfections in the market. He held that the price of labor was
determined in the same way as the other prices. He also justified
state
intervention
in
the market
on account
of
monoply.monopsony, hoarding and speculation. As per his views,
maintenance of fair competition and honest dealings were to be
ensured through enforcement of the Islamic code of conduct on
producers, traders and the middle men. His far most contribution
can be said of viewing state responsibilities by ensuring basic needs
of the people by organizing production and distribution.
Nasiruddin Tusi (1201-1274):- He discussed the revenue and
expenditure of the household as well as those of rulers. He
emphasized saving and warned against extravagance and
expenditure on unproductive products such as jewelry and
uncultivable land. He accorded supreme importance to agriculture
giving trade and other vocations a second place. On Public Finance
he disproves certain subjects which had no sanction in Islam.
Shah Waliullah (1702-1763):- He regarded economic wellbeing to
be a pre requisite of a good life and proceeded to discuss needs,
ownership, means of production, cooperation, distribution and
consumption. He also discussed evolution of society and regard
decadence coming from conspicuous consumption. On means of
production, he favors most of them to be in the hand of public
sector. He was highly against hoarding and profiteering for making
profit.
Mohammad Baqir al-Sadr ((March 1, 1935 – April 9, 1980) was an
Iraqi cleric, a philosopher, and ideological founder of Islamic dawa
party born in Iraq. Perhaps his most important work was
“iqtisaduna”, one of the most important works on Islamic
economics. This work was a critique of both socialism and
capitalism. He was subsequently commissioned by the government
of Kuwait to assess how that country's oil wealth could be managed
in keeping with Islamic principles. This led to a major work on
Islamic banking that still forms the basis for modern Islamic banks.
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In 1977, he was sentenced to life in prison following uprisings in
Najaf, but was released two years later due to his immense
popularity. Upon his release however, he was put under house
arrest. In 1980, after writing in the defense of the Islamic
Revolution, Sadr was once again imprisoned, tortured, and executed
by the regime of Saddam Hussein. Al-Sadr extracted two concepts
from the Holy text in relation to governance: khilafat al-insan (Man
as heir or trustee of God) and shahadat al-anbiya (Prophets as
witnesses). Al-Sadr explained that throughout history there have
been '…two lines. Man’s line and the Prophet’s line. The former is
the khalifa (trustee) who inherits the earth from God; the latter is
the shahid (witness). Al-Sadr demonstrated that khilafa
(governance) is ‘a right given to the whole of humanity’ and
explained it to be an obligation given from God to the human race
to ‘tend the globe and administer human affairs’. This was a major
advancement of Islamic political theory. Al-Sadr stated that the
legitimacy of a government in an Islamic state comes from the
people, and not from the clerics.
While Al-Sadr identified khilafa as the obligation and right of the
people, he used a broad-based exegesis of a Quranic verse to
identify who held the responsibility of shahada in an Islamic state:
First, the Prophets (anbiya’); second, the Imams, who are
considered a divine (rabbani) continuation of the Prophets in this
line; and lastly the marja’iyya (Parliament)
While the two functions of khilafa (governance) and shahada
(martyrism; supervision) were united during the times of the
Prophets, the two diverged during the occultation so that khilafa
returned to the people (umma) and shahada to the scholar.
Al-Sadr also presented a practical application of khilafa, in the
absence of the twelfth Imam. He argued the practical application of
the khilafa (governance) required the establishment of a democratic
system whereby the people regularly elect their representatives in
government
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'Islamic theory rejects monarchy as well as the various forms of
dictatorial government; it also rejects the aristocratic regimes and
proposes a form of government, which contains all the positive
aspects of the democratic system
He continued to champion this point until his final days
'Lastly, I demand, in the name of all of you and in the name of the
values you uphold, to allow the people the opportunity truly to
exercise their right in running the affairs of the country by holding
elections in which a council representing the ummah (people) could
truly emerge.
Al-Sadr was executed by Saddam Hussein in 1980 before he was
able to provide any details of the mechanism for the practical
application of the shahada (martyrism) concept in an Islamic state.
However on the basis of his above views he tried to explain role of a
State and individual in relation to economic relationships,
distribution of natural wealth, distribution of produced wealth,
Channeling human nature and economic development.
The model of Al Sadr is now in practice in Iran. In Pakistan one can
say that the concept is combined within Parliament and Islamic
Ideological Council. However these are just the beginnings and
people are still skeptical about these arrangements but going
forward room exists for making these arrangements more
meaningful.
Contemporarily lot of work is going on Islamic economics. Some
names in this regard can be of Chappra, Nijatullah, Mohsin and
Mirakhor. Forward going, there is very likely that economists on
conventional side stressing on values and welfare in economic
systems may converge with ideas of Islamic economists striving for
the same cause. However in regard to Islamic economics the ideas
of modern banking (getting their strength from monetized
transactions), paper currency (having no intrinsic value) and
inflation (assets to discount in time period) are still strange to the
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structure of its basic concepts but with further research answers
would no doubt emerge to the satisfaction for all.
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Chapter 9
Application of Islamic Economics on
disciplines of Micro, Macro,
Development and International
Economics.
There can not be two opinions that general economics as a social
science has grown to its height particularly when economic
connections have reached to the point of their globalization.
However growth of any science goes on without any end. It is like
that as much you know, you get aware of having less knowledge on
that particular subject. The growth of general economics has given
birth to various disciplines with prominent ones as Micro Economics
(economics of household and firms management), Macro
Economics (Economics dealing with national or global variables),
development Economics (economics dealing with policies to
develop low income countries) and international economics
(economics dealing with international trade and balance of payment
issues). Since Islamic economics is a new discipline hence this makes
it utmost necessary to find its relationship with the areas as
mentioned above.
In this regard we first take the framework of micro economics.
Consumption: - Consumption pattern determines the direction of
wealth creation in a particular society. Keynes aggregate demand
mainly depends on consumption and stresses for its use to counter
recession and inflation. However since this postulates follows with
no ceiling and floor and just assume position of full employment as
the basis for making decisions (that can not be attained practically
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under lazier faire environment), hence cycles of recession and
inflation go on repeating time and again. Islamic economics gives
due importance to consumption but is dictated by certain terms i.e.
halal and haram that goes in commodity market as well in the
financial transactions (in form of prohibition for Riba and gharar i.e.
uncertainty). Islamic economics stress for not expending on undue
goods i.e. not necessary as basic needs of life. If this is done than in
circle of consumption majority of people can be brought in that
would tend to increase volume of consumption resulting in
generating more employment in a society.
Consumer behavior: - Islamic economics do not deny concept of
marginal utility that with income streams determines the
equilibrium basis for the consumer behavior. But since this has to go
along with certain restrictions, so in ultimate, final spending would
remain within different patterns bounded by these restrictions
(halal and haram and not spending on undue needs). This would
make any one to save after exploiting his due utilities and
contributing a fair amount to the welfare activities. The savings are
subject to Zakat so a part of such savings would have a use for
elevating life of down trodden in any society. Consumer behavior in
Islamic economics is guided by the principle of living a prosperous
life but not a luxurious life. Being part of society, consumer has to
abide by the right of people, right of successor, right of poor, and
right of the government. In consumption of wealth the guiding
lights are principle of righteousness, Principle of cleanliness,
principle of moderation, principle of beneficence and principle of
morality. In terms of equation we can write it down as:Income = Spending as expenditure + Savings
Consumer spending as expenditure = Expenditure on goods and
services for own use + expenditure on welfare of society as directed
by Allah.
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Behavior of Firm: - Like conventional market, firm structure in
Islamic economics can be of partnership (Musharkah) or a
Corporate (Mudarbah) or a Cooperative like Takaful. Principles as
defined in Quran (Surah Baqrah) to run a firm or business entities
are principles of justice, principles of no injury and principle of
benevolence. Motives of an Islamic firm have been set as fulfillment
of ones need in moderation, meeting family liabilities, provision for
future contingencies, provision for posrtiety and provision to social
services and contribution to the cause of Allah. If one looks in to
these principles than one finds them in accordance with the
requirements desired by any regulator for getting any firm
registered or in accordance with the rules of corporate governance
framed by them for running any kind of business (however the
question of their due implementation remains a question mark).
In regard to these principles Holy Quran lays down that:“And eat not your property among yourself in vanity, not seek by it
to gain the hearing of the judges that you may knowingly devour a
portion of property wrongfully” Al Baqrah: 188.
“As for the thief both male and female cut of their hands. It is
rewards of their own deeds on exemplary punishment from Allah.
Allah is mighty wise” Al Maidah: 38
“O Ye who believe! Liquor, gambling, casting lots before idol or by
discharging arrows or by dice, are foul devilish acts avoid them” Al
Maidah: 90
“Allah permitteth trading and forbidden usury” Al Baqrah: 275
Monopoly, Oligopoly and free market: - Islamic economic system
believes on free market mechanism i.e. demand and supply forces
to interact in determining prices. In this regard in one Hadiths it has
been provided that ‘People said to messenger of Allah (PBUH)! Fix
the prices for us. On this the Holy prophet (PBUH) said: prices are
fixed by Allah. He contracts and expands the sources of livelihood”.
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Islam does not favor other kind of market imperfections like
monopoly and oligopoly. In this regard in a hadith it has been
clarified as “Holy prophet (PBUH) said: do not go out to meet riders
to enter in to transaction with them; none of you must buy in
opposition to another, nor you bid against one another: a
townsman must not sell for a man from the desert, and do not tie
up udders of camels and sheep, and the who buys them after that
has been done has two courses open to him, after he has milked
them he may keep them if he is pleased with them, or he may
return them along with a Sa of dates if he is displeased with them”.
For market business Islam favors contractual transactions on equal
terms. In a hadiths Holy prophet (PBUH) said “The contract of sale
becomes lawful with the consent of both the parties”. Further going
on this subject Holy prophet (PBUH) said “Both the parties in a
business transaction have the right to rescind it so long as they have
no transaction and if they speak the truth and make everything
clear they will be blessed in their transaction, but if they tell a lie
and conceal anything the blessing on their transaction will be
blotted out”
For a perfectly competitive firm, marginal revenue is equal to price
and average revenue. For a monopoly, monopolistically
competitive, or oligopoly firm, marginal revenue remains less than
average revenue and price, all three of which decrease on increase
of output. The constant or decreasing nature of marginal revenue is
a prime indication of the market control of a firm. To check such
decrease the monopolistic and monopolistically competitive firms
have to reduce the prices of their products.
However on the other hand perfectly competitive firms enjoy the
right to enter and exit at their discretion simply on the basis of price
dynamics in the market. This mechanism suits more to structure any
economic system on welfare and equitable basis and this is what
the Islamic economics stress for.
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Wealth: - In Islamic Economics wealth is regarded property of Allah.
In this respect first comes natural wealth i.e. land, water, air. As per
Islamic or any other interpretation it is the whole society that has
the right to exploit these resources without any distinction.
However going forward Islamic economics also recognizes the right
of ownership of that property that has been earned by some one
though his labor. But since basic right of any property still belongs
to Allah as to be exercised through Islamic state, so needs of all the
members of the society always remain paramount in making
economic decisions. According to Quran “Their wealth is a known
right of those who need it”. Islamic economics in fact stresses on
circulation of wealth rather than making it captive in some hands.
However for making the system workable it stresses on making
demand and supply factors justifiable and working relations
structured on capacity to deliver. Quran says in this regard that.
“Allah have distributed livelihood among them for their worldly life
and some of them are preferred over the other so that they may
use the services of others for them”.
In Islamic economics capital means those factors which can’t be
used till they are fully consumed. So by this definition one can not
rent out certain items like food or money or other durables.
Land in Islamic economics has been defined as a resource used in
the process of production without change in its original form.
Labor in Islamic economics covers mental as well physical labor
meaning that it includes factors of planning and management of an
organization both as part of it.
In discipline of Islamic economics what ever is produced is regarded
due fruit of combined efforts of above given components of wealth.
So accordingly profit is distributed on equal share basis among
capital provider, land owner and laborers.
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Apart from above first co sharers of wealth, Islamic economics also
stresses for providing support to remaining segment of the society
by defining them second co sharers of the wealth. The profit to
these second co sharers of the wealth can be delivered through
Zakat, Ushr, Sadaqat, Kaffalat, heritage and Nafqaat (supporting
near relations). Islam obligates upon Muslims to regard the
conditions of their Muslim brothers, wherever they may be. In this
regard following sayings of Prophet (PBUH) are very evident.
“The believers in their love, mercy and their feeling for each
other are like one body: if one part feels pains, all the other
parts feel pain through fever and sleeplessness.” [Muslim]
Islam orders that Muslims strive to improve their condition. The
Prophet (PBUH) said:
“None of you believes until he loves for his brother what he
loves for himself.” [Al-Bukhari]
It orders that Muslims stand by their brothers at times of crises and
agony. The Prophet (PBUH) said:
“The believers are like a solid structure, each one (brick)
strengthens the other (and then he clasped his hands and
intertwined his fingers).” [Al-Bukhari]
It orders that Muslims come to the aid of their brothers and assist
them in times of war if they are in need. Allah (I) says:
(And if they seek your help in Religion, it is your duty to help
them…) [8:72]
It forbids that they be forsaken in their time of need. The Prophet
(PBUH) commanded that the Muslims support their oppressed
brothers. [Al-Bukhari].
Rent: - In Islamic economics It is not permissible for a transaction to
be accompanied by a condition of giving a loan; if the lender will
benefit from this loan by having the price reduced or anything else,
then that benefit would come under the definition of Riba. It is
proven that the Prophet (PBUH) forbade combining a sale with a
loan, and he (PBUH) said: “It is not permissible to arrange a loan
combined with a sale.” Narrated by Abu Dawood (3504) and al-
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Tirmidhi (1234); classed as hasan by al-Albaani in Irwa’ al-Ghaleel
(1307). This definition creates some suspicion about Murhabah
(leasing) that is mostly in practice by the Islamic banks now a days
However apart from this, Islam allows use of private property as for
its beneficial use. In regard to holding property, Islam gives right of
their use for own and other beneficial purposes like using them in
business, Right of transfer, right of their protection and right of
increasing their worth. The use of property on rent is permissible
but is limited to those articles which one terms as durable goods
like machine, land or house. The perishable goods can not be given
on rent. Islamic economics set three basic principles for rent i.e.
Justice, benevolence and negation to oppress someone else.
Ricardo one of the proponents of political economy has defined rent
as indivisible power of land justifiable under rule of depreciation.
Some of the Islamic economists do not agree with this definition as
acceptable to Islamic principles. They treat rent as such as
equivalent to Riba. However Ricardo was living in the age when
feudal economy was more dominant. Now under current scenario
economic rent is defined as margin that one gets after adjustment
of its capital expenditure, so this definition is quite close to what
has been defined by the Islamic economists on rent.
Wages: - In regards to work and employment, Islam introduced
principles and guidelines which define the relationship between the
employer and the employed. Islam enjoins that the relationship
between employer and employee should be based upon principles
of brotherhood, equality and dignity. The Prophet (PBUH) said:
“Your servants are your brothers whom Allah has placed under
your authority. Whoever has his brother under his authority, let
him feed him from what he eats and clothe him with what he
wears. Let him not burden him with more than he can bear, and
if you do, then help him.” [Al-Bukhari]
Islam has guaranteed their right to receive wages. The Prophet
(PBUH) narrated from Allah that He said:
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“I will stand against three types of people on the Day of
Requital: a person who swears by Me and then betrays his oath,
a person who sells a free person and eats the money he gains
from it, and a person who hired a workman, takes his full due [of
work] from him but does not give him his right (his wages).” [AlBukhari]
It also orders that the wages be negotiated before work begins. In a
Hadeeth collected by Ahmad, the Prophet (PBUH) forbade hiring a
workman before negotiating his wages.
Islam also commands that wages be paid immediately after the task
has been completed. The Prophet (PBUH) said:
“Pay the workman his wages before his sweat dries.” [ibn
Majaah]
They are not to be given more work than they can bear; if he is
given more than he can bear, than he should be given extra wages
or help. The Prophet (PBUH) said:
“Let him also not burden him with more than he can bear, and if
you do, then help him.” [Al-Bukhari]
In order to raise the honor and dignity of labor, the Prophet (PBUH)
said that it was the best and most pure of earnings, if done through
permissible means. The Prophet (PBUH) said:
“No person has eaten better food than that which [was bought
from the wages which] his own hands toiled. Indeed David (u),
the Prophet of Allah, ate from what his own hands earned.” [AlBukhari]
To encourage manual labor, the Prophet (PBUH) said:
“By Him in Whose Hands is my soul, if one of you goes and chops
wood, ties it, and carries it on his back, it is better for him than
to beg people, whether they give him money or not.” [AlBukhari]
As Islam required the employer to give the employee his due rights;
the employees should also observe the rights of the employer…they
should carry out the work in the best manner, without delay or
shortcomings. The Prophet (PBU) said:
“Indeed Allah likes that if one of you performs some work, that
he does it perfectly.” [Abu Ya’laa]
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In order to encourage people to do their assigned work properly
and sincerely, Islam has made this type of wages from the best of
earnings. The Prophet (PBUH) said:
“The best of earnings are those earned by working sincerely and
properly.” [Ahmad]
Macro Consumption functions: - Great depression of 1930 in the
US remaining active for six years brought forward three important
questions. They were: - What can be the components of aggregate
demand in an economy? What determines the level of spending for
each component and can there be enough demand to maintain full
employment? Keynes tried to find out its answers. To start with, it is
a known fact that aggregate demand and aggregate supply confront
each other in the marketplace to determine macro equilibrium.
Aggregate demand is defined as the total quantity of output
demanded at alternative price levels in a given time period, whereas
Aggregate supply is the total quantity of output producers are
willing and able to supply at alternative price levels in a given time
period, ceteris paribus. Here it must be understood that Macro
equilibrium may or may not be at full-employment as all economists
recognize that short-run macro failure of unemployment is possible.
Here there is a debate that whether Aggregate Supply and
Aggregate Demand will shift on their own to reach full
employment. John Maynard Keynes asserted that high
unemployment was likely to be caused by deficient aggregate
demand. He further said that a market driven aggregate demand
curve might not shift when needed. Aggregate Demand is
comprised of four components i.e. Consumption (C), Investment (I),
Government spending (G) and Net exports (X - IM). In this regard
most important one i.e. Consumption expenditures are spending by
consumers on final goods and services. Keynes believed that the
amount consumers decide to spend is determined by their
disposable income i.e. after-tax income of consumers—personal
income less personal taxes. By definition, all disposable income is
either consumed (spent) or saved (not spent). Hence The
Consumption Function is a mathematical relationship that helps to
predict consumer behavior. Keynes noted that consumption is
determined by Expectations, Wealth, Credit, Taxes and Price
Levels. Shifts in the consumption function that plays major role in
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uplift or crash of an economy are reflected in shifts of the
aggregated demand curve. Shift factors include changes in
consumer confidence (expectations), Changes in wealth, Changes in
credit conditions and Changes in tax policy. So from this one can
conclude that as a rule of thumb if consumer spending increases
abruptly, demand pull inflation will follow. Investment on the other
hand are expenditures on (production of) new plant, equipment,
and structures (capital) in a given time period, plus changes in
business inventories and they are affected by Expectations, Interest
rates and technology and innovation. Investment spending
fluctuates more than consumption. Abrupt changes in investment
were the main cause of the 1990-91 recessions in the US.
Now with these postulates Islamic economics enter in to the scene.
It is generally said in this case that with spending limited to needful
items one can tempt to move towards more savings that can hurt
investments. It may be true to some extent but In the first case this
behavior and restriction puts a brake on demand pull inflation and
secondly in case of savings the consumer is bound to pay Zakat for
its use on welfare activities and to support low income group that in
the long run creates more consumption making the environment of
investment quite attractive. As regards rate of Zakat it must be
understood that for its deduction 2 ½ % is the minimum rate and
one can go beyond it as per his capacity. Islamic economics thus
makes the income, consumption and investment relationship more
rationale
Role of a State in development economics: Development
economics is regarded as a study of how to increase wealth in
countries that are changing from an agricultural economy to an
industrial one. Economic development is the increase in the
amount of people in a nation's population with sustained growth
from a simple, low-income economy to a modern, high-income
economy. Its scope includes the process and policies by which a
nation improves the economic, political, and social well-being of its
people The 3 building blocks of most growth models includes the
production function, the saving function and the labor functions.
The last one is in fact human development function that plays an
important role in the uplift of production function. Amrita Sen, the
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economist of India who earned Nobel Prize in economics in 1998
has made revolutionary contributions to the development
economics and social indicators recently. He has produced the
concept of “capability” ' developed in his article "Equality of What."
He argues that government should be measured against the
concrete capabilities of their citizens. This is because top-down
development will always trump human rights as long as the
definition of terms remains in doubt (is a 'right' something that
must be provided or something that simply cannot be taken away?).
For instance, in the United States citizens have a hypothetical
"right" to vote? To Sen, this concept is fairly empty. In order for
citizens to have a capacity to vote, they first must have
"functioning." These "functioning’s" can range from the very broad,
such as the availability of education, to the very specific, such as
transportation to the polls. Only when such barriers are removed
can the citizen truly be said to act out of personal choice. It is up to
the individual society to make the list of minimum capabilities
guaranteed by that society
Agreeing with Sen., Islamic economic thoughts from its beginning to
last stress on brotherhood, peace and economic welfare of all well
beings through cooperation. In Islamic economics the role of State is
central in getting such ideas materialized. For this, government and
specifically the institutions working under the label of Islamic
financial institutions and in general all financial institutions have to
come forward through providing schemes and funds for uplift of
education, health and infrastructure. Further their main task should
be to work on low income group specifically living under poverty
line. As an example, Indonesia is on lead in providing micro fiancé
following mode of Islamic financing. Likewise Iran is experimenting
extension of Qardae Hasna (Loan without interest) as consumer
financing though all of its banks.
Islamic economics and international trade: - During the height of
the great Islamic civilization, trade was among the most important
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activity in wealth creation. Today in a world that is being rapidly
globalized, trade has become even more important, facilitated by
the advancements in information and communication technology
and the greater capacity and speed of transportation. Whereas in
the past trade could be carried out through the barter of goods this
has yet to be decided that the Muslim world would still have to
trade now with the rest of the world as individual countries or as a
regional group or as an Islamic Financial Community. Further with
appearance of IMF, World Bank or other multinationals the world
trade has become more complex. WTO on the other hand is striving
to bring about a unitary system for the world trade. Islamic
economics stress for transparency in trade, honoring of contractual
obligations and lastly to use currency of exchange with intrinsic
value, hence it can play a model in realization of these efforts. To
initiate this process, with this blue print in hand, at least a block of
Islamic countries needs to emerge like EMU or other regional blocks
using gold as currency of exchange for the settlement of trade
within countries of Muslim block. In international trade the
settlement on trading activities are not issues for Islamic economics;
however the matter becomes different when current account or
balance of payments becomes positive or goes negative. In the first
case the excess funds are to be invested somewhere and in the
second case the gap is required to be plugged through deficit
financing. Both issues can be sorted out through development of
Sukuk market and by strengthening Islamic Development Bank to
play role of World Bank and of IMF simultaneously as provider of
finance for development and for balance of payment support.
Secondly World Bank and IMF can also be asked to use Islamic
mode of financing (through project financing/securitization) to
access funds or to deliver funds. Moving towards this mechanism
would obviously create more stability on the scene of world
economic architecture.
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Chapter 10
Fiscal and Monetary policy
framework in Islamic Economics
In layman terms fiscal policy means management of government
revenues and expenditures and monetary policy means
management of price stability so as to obtain GDP growth. Both are
complementary to each side, but opposed in their operational
designs. Since price stability depends on quantum of money supply
that can be altered through government expenditure or taxation so
in this respect they complement each other. But operationally
government is more concerned for making its debt financing cost
effective that has little correlation with the central bank operations
in managing interest rate structures, so in that respect they are
opposed to each other.
Objectively Islamic finance is not different from conventional in
running fiscal and monetary policies but since its financial
transactions are to be carried out under some restrictions so in that
respect they have to be amended and redesigned in accordance
with these tenets.
The basic question in fiscal and monetary policy is that what can be
the right amount of money that can bring desired fiscal and
monetary policy results.
In regard to Islamic Finance first of all one has to recognize that its
non recognition of time value of money (inflation) can only be
realized when Islamic financial system would be fully adopted i.e.
based on interest free trading having underlying assets with no
speculative activities and by investing only in halal businesses and
commodities. However since the system is at its infancy, hence the
concept of time value of money can neither be tested nor realized
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till such stage is realized. So right now we have to contend with a
transitional arrangement i.e. a mix of conventional with Islamic
finance.
Saying this it does not mean that a blue print of Islamic finance
many not be searched upon.
Some quarters argue that paper money is not acceptable in Islamic
finance. Their argument is based on the assumption that it is not
supported with any intrinsic value. This is wrong since any currency
as liability is backed by some assets. However this can be argued
that such assets are just paper transactions (fiat money) or they do
not exist in reality. Apart from this the fact is that any currency
issued by the government is an explicit liability of that particular
government, hence its exchange value remains above any dispute.
However the question of its changing value always remains under
debate.
General economics from its beginning has tried to find out the right
amount of money for any economy. Says law under classical
economics deals with interest rates, employment, production and
quantity theory. Says famous maxim was that “supply creates its
own demand”. It was supported by the interplay of market forces as
referred by Adam Smith as “invisible hand”. As an economic model
it assumes that under given technology, potential output of
economy would be determined by the size of its labor force
available to work with the existing stock of capital goods. The
production hence defines total supply of goods and services that
can be produced. Say argued that production would be at full
employment since spending would always be great enough to buy
all the goods and services that can be produced.
Here than comes the function of investment and savings. Saving as
per classical economics is the function of interest rate, the higher
the rate of interest the more would be saved. Investment on the
other hand is the function of rate obtained after employment of
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capital goods and that should be higher than the interest rate i.e.
borrowing cost. So in this respect low interest rate suits more for
investment. This interaction goes on towards equilibrium but in real
world the same can not be realized.
Classical economics also relied upon quantity theory of money that
says MV= PY, where M is the supply of money, v is the velocity or
rate of its turnover, P is the price level and Y is the level of real
income. The theory states that the impact of money is limited to the
price level. At the heart of quantity theory lays stable demand for
money.
Than comes Keynes, that maintained that the level of production is
determined by the aggregate demand for goods and services. This
differed from classical economists that regard production to occur
at full employment whereas Keynes thought that fluctuating prices
and interest rate would push the economic activity toward full
employment especially in the short run. The Keynesian model
focused on the determinants of aggregate demand i.e.
consumption, investment and government expenditure. Changes in
money supply alter the level of interest rate in the Keynes
framework. In fact in this, three transmission mechanism link
monetary policy to GDP i.e. cost of capital channel through
investment spending, wealth channel through consumption and the
exchange rate channel through net exports.
Onward comes the ISLM analysis. In fact it is a complex model of
GDP determinants that shows how monetary and fiscal policy
interact, it shows how the money multiplier effects on each and it
provides a partial integration of classical and Keynesians systems in
to one conceptual framework. The ISLM model can be viewed from
Fig.1 where I stand for investment, S for savings, L for liquidity
preference, M for Money supply, i for interest rate and Y for
income. The slope of ISLM states that if LM curve would be steeper,
than the greater would be the income sensitivity of demand for
money and the less would be the interest sensitivity of demand for
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money: In case the LM curve would be flatter than the less would be
the income sensitivity of the demand for money, and the greater
would be the interest sensitivity. The extremes vertical curve of IS
and horizontal curve of LM makes the monetary policy impotent
and fiscal policy supreme. On the other hand vertical curve of LM
makes the fiscal policy to loose its potency and raises the monetary
policy to its ultimate power.
Onward going monetarists comes in, who suggest that though fiscal
policy has a direct and powerful impact on spending but they
disappear because rising interest rates crowd out private
investments. According to them inflation is the monetary
phenomenon because aggregate demand depends primararily on
money supply. The existence of a Philips (a newzeland economist)
Curve trade off between inflation and unemployment depends
upon the lags of wages and expectations behind changes in the
price level. Real interest rates initially falls after an increase in the
money supply but once inflationary expectations take hold nominal
rates rise.
Fig.1
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Now we come to the question of actual operational frameworks of
monetary policy. In this regard some economic variables (monetary
aggregates) are required to be understood. They are:M-0 Reserve Money = Currency in circulation+ commercial banks
deposits with central bank including excess reserves and Cash
reserve requirements of central Banks+ other deposit account of
central bank + Cash in tills with the commercial Banks. Reserve
Money can also be defined as RM= Net Foreign assets (NFA) + Net
Domestic assets (NDA)
M1= Currency in circulation + demand deposits of commercial
banks.
M2= Currency in Circulation + Demand deposits + Term Deposits +
Foreign Currency Accounts maintained with the commercial Banks
M3= Currency in Circulation + Demand deposits + Term Deposits +
Foreign Currency Accounts + National Savings Accounts
Money Multiplier = M2/RM
Here it may also be noted that in most of the countries interbank
market comprised of commercial banks are used to implement
monetary policy operations i.e. through outright sale/purchase of
securities, auction of government securities or Open market
operations through Repo or reverse repos (short term collateralized
transactions through buying or selling of securities). However it is
not necessary. In some countries like Turkey, capital market brokers
are also considered part of this arena or in USA only Primary Dealers
(mostly banks) appointed by the Federal Reserve can participate in
such kind of operations.
Monetary policy is implemented by the Central Banks at three
levels. At first level, the central banks carry out their operations by
targeting reserve money so as to get targets set for the monetary
aggregates or interest rate or exchange rate or some inflationary
number. In the second phase it tries to achieve a number for M2 or
M3, exchange parity or inflationary number set by the
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government/central Bank. In the third and as final objective it tries
to achieve Real GDP growth in line with Inflationary number set for
the year. In Pakistan as operational target we set interest rates by
altering reserve money (started onward Sept 2009). For second step
we target M2 and as final target we go for inflationary number and
real GDP growth rate set for the FY. For instance for FY10, the real
GDP growth rate has been set as 3% and inflation i.e. CPI is
expected to be around 12-13% pa. So obviously under this
framework M2 growth should remain around 15-16% pa. However
in all these operational steps the central bank only alters RM to
influence interest rate, exchange rate or number of inflation. Going
forward if objective is to go for monetary aggregate targeting than
central bank would remain focused only on liquidity management.
In case of interest rate targeting it would do it through altering RM
but remaining focused for getting desired interest rate. The same
goes for exchange rate and inflation targeting.
Now after getting somewhat understood about monetary policy
execution framework and its relationship with fiscal policy we come
to the question of monetary and fiscal policy framework in Islamic
finance. Here we have skipped the quantitative side of monetary
policy required to set the targets of RM as that requires resorting to
regression models which are separate to deal with.
Moving to the Islamic Finance, first of all we have to understand the
balance sheet constituents of Islamic Financial Institutions (IFIs) and
particularly Islamic banks (IBs) as compared to their conventional
counterparts. The Fig 2 provides this detail:Fig:-2
Conventional
banks
Assets
Loans
and
Advances
Cash in tills
Islamic Banks
Liabilities
Deposits
Due
to
Assets
Financing
assets
(Murhabah,Salam,Ijarah,
Istisna)
Investment
assets
Liabilities
Demand
deposits
(amanah)
Investment
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Islamic Economics
other
banks/FI
Other
liabilities
(Mudarbah, Musharkah)
Financial assets for
trading
Sundry
Creditors
Cash with central
Bank
Non banking assets
( Property)
Equity and
Reserves
Fee
based
services
(Juala, Kafala and so
forth)
Non banking assets (
Property)
investments
Cash
accounts
(Mudarbah)
Special
investment
accounts
(Mudarbah,
Musharkah)
Reserves
Equity
Looking in to the balance sheet of the Islamic banks i.e. the arena
for implementation of monetary policy, it is evident that its
constituents are different from conventional banks in two main
respects. I.e. their transactions have to be interest free and
secondly they have to be based on some underlying assets. To
conform to these two tenets within monetary policy framework,
most of the countries either do not have infrastructure available or
lack in legislation.
Second difficulty is that Financing assets (as they can also be formed
against debt financing) are not tradable whereas investment assets
do have this quality. So what is required is to focus on investment
assets formation i.e. based on Musharkah, Mudarbah or Ijarah if
one wants to see an Islamic money market to come in to reality.
The third difficulty is that on conventional side when central bank
mop up the funds it becomes dead money but in case of Islamic
banks it can not do like that as in this case any funds received would
be followed with some underlying assets that has to be accounted
for. However this can be sorted out by making these transactions
circular in some sense i.e. finding some ways again to employ these
assets in some business. In that way Central Bank becomes part of
commercial activities that creates problems and conflict of interest.
Bank of Indonesia has resolved this problem by accepting funds
through Wadiah where central Bank is not bound to receive any
assets. This mode can be adopted elsewhere.
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However before dwelling on these ideas further, first we come to
the question of fiscal policy mechanism in Islamic Finance.
Islamic Finance is very simple on this and stresses for a welfare state
with government to undertake development of the society far most.
Zakat has always been stated as cornerstone for running the state
affairs but this is not absolutely true. Zakat is based on the concept
of welfare and was promulgated to elevate life of down trodden
and to help them out of their mess. The prime objective of Zakat is
to enhance welfare in a society. If collected with sincerity it can add
up income of needy class and ultimately would affect consumption.
If one looks in to the balance sheets of current governments than it
finds two major subheads under its expenditure. One is meant for
current expenditure and the other is meant for development. Time
and again it has been argued that emergence of inflation onward
1919 has occurred due to the fact that governments have started
expending much on developmental side. This may be true in the
earlier stages but now most of the budgets are swallowed by their
current expenditures. They include expenses incurred on ruling
classes and heavy expanses to maintain war machinery. On the
other hand governments now expend very little on the
development of the society.
So running the government through current or developmental
expenditures should be treated separate from Zakat funds. In 200809, In case of Pakistan, collection of Zakat remained Rs 170 billion.
Further Government allocated Rs 42 billion for Benazir Income
support funds. If we compare these figures with current and
developmental expenditures that go around Rs 3 trillion than these
amounts look quite meager and insufficient to meet government
expenditures. So in a way there is no match of Zakat Funds with
expenditure of the government. For that government has to resort
to taxation and to go for deficit financing.
In case of Islamic economics, if followed, makes the governments to
tax on the principle of equity and convenience. In regard to debt
financing they have to borrow to the extent of their assets either
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through Ijarah or other mode of financing. To facilitate market for
monetary policy implementation governments are required to focus
on issuing Musharkah or Mudarbah certificates (having feature of
tradability). Islamic mode of financing automatically put a restriction
on the governments to borrow to the extent of their assets. So in
nut shell the fiscal policy of the government should be based on
following principles
1. Collection of Zakat only for the use of welfare and
developmental activities in the interest of the society.
2. Tax policy based on equity and convenience.
3. Deficit financing preferably by issuing Musharkah and
Mudarbah certificates. As last resort other modes like
Ijarah, Salam, Istisna, Murhabah can be used.
4. Further restriction on government borrowing i.e. linking it
with some % of revenue. Like in Sudan government can not
borrow more than 25% of its estimated revenue; in a small
country like Magnolia i.e. not a Muslim country,
government can not borrow more than 10% of its revenue.
5. Major allocation towards developmental projects.
6. Restriction on production of undesired and luxury goods
and of their imports.
Now coming back to the question of monetary policy under Islamic
Finance one has to accept that currently no formidable model exist
in this respect or is in practice. This goes with the conventional side
as well where on each crisis things start changing though they have
some consensus on its broader outlines.
In regard to monetary policy operations in Islamic Finance, directed
lending or credit ceiling advised by the central Banks are being
followed to some extent in some countries like Iran and Sudan
where Islamic monetary policy framework exists to some extent.
But the results are not satisfactory. In Iran and Sudan the inflation
CPI has never come down in single digit. In Iran it has always floated
above 16%. Further in credit ceilings and directed lending, you
never know the quantum of credit demand from various sectors in
real sense. However in addition to direct lending, these countries
are trying to build their money market through government and
Central Bank Musharkah certificates and OMOs and lender of last
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facility through use of these certificates. In Iran they also use
different margin rates against Musharkah certificates to give
monetary policy signals. In Malaysia the Islamic money market is
more active and has its own settlement system but Bank Negara
mainly use conventional side covering 85% of banking assets to
settle its monetary policy scores.
Another question which is very important and has been tested is
that interest rate targeting is more resultful rather than monetary
aggregates in guiding monetary policy signals. In Islamic finance this
can be used as targeting profit oriented objectives rather than going
for simple monetary aggregates. However these are the suggestions
which would come for testing in Islamic financial models after some
time that no body can explain right now.
Another question i.e. very important is to understand that almost
50 Islamic countries where monetary policy framework is to be
tested are confronted with different ground realities. Some with
petrodollars are surplus in current accounts and pegged with dollar.
Others are deficit running countries. Some are export oriented like
Malaysia, Indonesia. So each country has to build their monetary
policy framework based on their ground realities and in line with
Shariah principles that would be common for all.
To better under stand the issue we take the example of Pakistan
where we are entangled with basic issues of creating monetary
policy execution framework for Islamic Banks.
First one is the creation of a vibrant and dynamic Islamic Money
Market (IMM) i.e. the basic pre requisite for developing Islamic
Finance and to make them part of monetary policy operations in
Pakistan or even in any other country. Currently the share of Islamic
banking in Pakistan stands at a modest 5% against total banking
sector. However its pace of growth is immense and deposits of
Islamic Banks (IBs) have grown by almost Rs. 300 billion during last
2-3 years. 6 full fledged Islamic Banks (IB’s) and 13 Conventional
Banks having Islamic Windows (IBBs) with a network of around 500
are now operating in the market.
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To sustain this growth, development of IMM becomes the priority
area as Islamic Financial Institutions (IFIs) are now maintaining
3.81% as excess reserve for their TDL, while conventional banks
have to maintain only 0.27 % excess reserve for their TDL on an
average weekly basis. This affects their competitiveness vis-à-vis
conventional peers. This has posed the challenge of bringing Islamic
banks in to the ambit of liquidity management framework with
ample number of securities (most importantly Sovereign), trading
facilities, market infrastructure particularly for clean and Repo
interbank transactions, pricing disclosures and settlement
mechanism.
Currently in a system of parallel Banking, SBP is not incorporating
IBs in to its day to day monetary operations since there is no Shariah
Compliant monetary policy instrument through which it can deal
with these institutions. So for understanding purpose the given brief
of monetary operations in Pakistan only covers the conventional
market that encompasses deposits to the tune of Rs 4.0 trillion as
compared to Rs 300 billion of IBs.
Like many central banks, SBP has used monetary aggregates as
indicators in its policy framework. SBP has accorded a high priority
to achieving a low rate of inflation. Monetary policy has also been
aimed to support the national objectives of economic growth and
ensuring export competitiveness of the country. However, the
distorted terms of trade for most of the years in the last three
decades have contravened the conduct of monetary policy, which
has been geared towards the task of reconciling inflation control
with external competitiveness. Moreover, monetary policy
remained subordinated to fiscal needs till the reform process took
its roots. Legal framework for market-based monetary policy was
altered; changes in the SBP Act were introduced in 1993 to make
SBP responsible for the formulation and implementation of
monetary policy. The Act is now required to be changed to establish
SBP relationship with IFIs in regard to different mode of financing.
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Islamic Economics
Financial Sector Reforms initiated in early 1990s provided the
required framework for moving towards market based monetary
policy. In this regard market based Treasury Bills were introduced
followed by Federal Investment Bonds (FIBs) and now Pakistan
Investment Bonds (PIBs) in place of FIBs. MTBs are of 3, 6 and 12
month tenors whereas PIBs are of 3, 5, 7, 10, 15, 20 and 30 years
tenors. The MTBs are available at discount through fortnightly held
auctions, whereas PIBs are available at par through quarterly held
auctions with profit payable on biannual basis. This has created a
benchmark yield curve up to 30 years and has developed a
correlation of market rates with SBP policy rate i.e. discount rate
(the rate at which SBP provides funds to the banks as lender as last
resort) which is used to give monetary policy signal to the market.
However such yield curve is yet to be developed based on Shariah
compliant instruments.
The foremost step towards market based policy was the
introduction of Open Market Operations (OMOs) in January 1995
followed by removal of caps on maximum lending rates in March
1995 and the abolition of floors on minimum lending rates for
project and trade related financing in July 1997. 2005 onward SBP
digressed from its monetary aggregate targeting and has shifted
towards interest rate targeting maintaining implicit target
benchmarked to 3 month MTB cut offs. Now the shift has been
made towards explicit target since Nov 2009 onward.
MTB auctions/OMOs/discount window/swap window/ are the main
tools used in monetary policy operations and in all these areas IBs
are not able to participate due to non availability of Shariah
Compliant instruments. Only against reserve requirements they
have to oblige as per following chart.
Reserve
Requirements
Cash
Conventional Banks
Islamic Banks
Reserve 5 % of Total Demand 5% of Total Demand
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Requirements
(CRR)
Statutory
Liquidity
Requirement
(SLR)
157
liabilities and Time liabilities and Time
Liabilities of less than 1- Liabilities of less
year tenor
than 1-year tenor
19% (excl. CRR) of Total 9% (excl. CRR) of
TDL
Total TDL*
* Currently Soverign and some quasi-sovereign Sukuks are eligible
for SLR however they have to be kept within 5% of TDL of IFIs.
Going above 5%; IFIs have to provide 3% in cash against their TDL
for SLR in addition to 6% of TDL as CRR. On availability of
Sovereign/Quasi Sovereign Sukuks in future, obviously the SLR for
IFIs would be the same as for Conventional Banks.
As regards exchange rate regime, Pakistan moved in a phased
manner in liberalization of its foreign exchange policy for the
promotion of exchange rate stability. Pakistan had to abandon fixed
exchange rate and move towards managed and then to free float
with a cap on its downward movement till the rupee was finally set
on free float exchange rate from July 21, 2000. The recent
refinement of monetary policy framework to focus on inflation
modeling and control would obviously have its implications for the
exchange rate regime. Being a small open economy, Pakistan need
to stabilize its exchange rate as it is generally believed that
exchange rate volatility has an adverse impact on trade flows.
Exchange rate volatility leads to uncertainty, which has negative
implications on both Exports and Imports. In the recent past SBP has
always remained focused on the critical role of controlling real
exchange rate in maintaining external competitiveness.
To make Islamic Financial Institutions (IFIs) part of monetary
operations, following pre requisites are necessary:-
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158
1. The first pre requisite is the development of GOP/SBP
Shariah compliant instruments and Primary Market with
supporting financial infrastructure especially for Repo
transactions.
2. In the second phase developmental issues relating to
secondary market activities within interbank and with
Central Bank including OMOs and facility of lender as last
resort facility comes in.
3. Finally issues regarding payment system and dissemination
of information and reporting system needs consideration.
To meet the liquidity management of IBs/IBBs, Government has
issued 3 years Sukuk based on Ijarah mode of financing. However
there is a need to issue Short Term Tradable Sukuk based on a
Hybrid Sukuk (Ijara + Musharaka or Murabaha). Why because there
are less number of Unencumbered Government owned assets or
problems in their identification for issuing instruments based on
Ijarah.
Now coming for the Repo transactions that are sale and
simultaneous buy back from same counter part. It falls under the
category of “bai-al-Inha” or buy back in Islamic Finance which is not
permissible in Shariah. For these, following three options can be
exercised. Under Option – 1, there are possibility of Repo structure
via two outright transactions i.e. spot sale contract and future
promise to purchase. Under Option- 2, after commencement of
GOP/SBP/PSE’s Sukuk in the market these transactions would
become easy and would develop the secondary market of Islamic
Banks. In this Bank A would enter in to a repo transaction with bank
B to sell WAPDA Sukuk of Rs 100 million for a week and under take
a promise to purchase the SSGC Sukuk of Rs 100 million on some
future date or at the time of maturity of the first transaction. The
price mechanism and profit margin will be adjusted through face
value of the second transaction. Under Option-3 the fund provider
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159
IFI can demand pledge of Wapda or SSGC Sukuk from Fund Manager
IFI to secure refund of its placed funds.
For SBP intervention for liquidity absorption, Wadiah Acceptance
can be adopted. It refers to a mechanism whereby the Islamic
banking institutions place their surplus fund with the Central Bank
based on the concept of Al- Wadiah. Under this concept, the
acceptor of funds is viewed as the custodian for the funds and there
is no obligation on the part of the custodian to pay any return on
the account. However, if there is any dividend paid by the
custodian, is perceived as 'hibah' (gift). Under the liquidity
management operation, Central Banks uses the Wadiah Acceptance
to absorb excess liquidity from the IBs/IBBs by accepting overnight
money or fixed tenure wadiah.
For lender of last facility to IBs/IBBs following mechanism can be
pursued: - Under Option-1 by replicating SBP Islamic Export
Refinance Scheme (IERS). Musharaka based investment pool
mechanism can be introduced for Islamic financial institutions to
access lender of last resort (LLR) facility. The frame work of this pool
is on the basis of profit and loss sharing. In case the actual profit of
the pool is more than SBP discount rate i.e. 12.5 %, the excess profit
so received by SBP would be credited to the Takaful fund to meet
future losses arising on implementation of Shariah Compliant
Lender of Last Resort(SCLOLR. ) As option No 2 State Bank may
allow Islamic banks to use Sovereign/ Quasi Sovereign Sukuks for
(SCLOLR) facility. For this purpose SBP would have to use depository
facility of CDC in case of SCLOR and SGLA (SBP Securities account)
for Sovereign Sukuk. Further for this short term facility, both sides
would have to sign two agreements i.e. one for buying the
instruments with promise for their buy back on some future date.
In case of FX ready deals the same can be used by IBs/IBBs for the
liquidity management without any issue, however for Swap they
have to adopt same kind of arrangement as proposed for Repo
Market above.
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160
For rate dissemination mechanism Pages on Reuters can be
developed for dissemination of Islamic MM rates replicating current
experience for developing such pages for Conventional Banks.
Concluding it can be said that in developing country like Pakistan,
the central bank holds the responsibility to lay down and to improve
Islamic Money Market through its active role and by designing its
products/ infrastructure for the use of the Islamic banks to manage
their liquidity comfortably. Currently the critical mass in form of
deposits held by the IFIs is not significant as compared to
Conventional Banks so practically it does not bother much to the
Central Bank to show keenness in making IFIs part of its monetary
policy operations. However it is very important from IFIs perspective
to become part of monetary policy operations as they are facing
difficult time in managing their liquidity and in this regard obviously
they need Central Bank support to become competitive at least with
their counterpart Conventional banks. For this SBP has to strive hard
to provide them all facilities which conventional bank have i.e.
consistent supply of Shariah compliant Sovereign instruments,
secondary market infrastructure/ Windows like OMOs, lender as
last resort facility to place/access funds from the SBP.
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161
Chapter 11
Defining Riba and Islamic Banking
Mahmoud-A-el-Jamaal in his book “Islamic Finance”: has quoted a
historical event that five hundred years back Martin Luther in his
address to German nobility wrote that a cobbler, a smith, a peasant,
every man including priests and bishops should function useful and
beneficial to others. At this a cobbler asked Martin Luther that how
he can serve God working within his trade. Martin Luther replied that
he is not supposed to produce a Christian shoe but he is supposed to
produce a good shoe and sell it at a fair price. In this way he can
serve his God better.
This quote is almost similar to what we are doing with Islamic
Finance or Islamic Banking. The term Islamic Finance or Islamic
banking brings in to mind the concept of Christian shoe rather than
good products with a fair price. Infact, Islamic finance or Islamic
Banking is a combination of two words; Finance or Banking reflects
the current financial or banking system and by adding Islamic we
just make it conditional. This is what the definition of Islamic
banking or finance can be. However the dilemma is that by coining
word of Islamic Finance or Islamic Banking we have deviated
ourselves from efficiency and fair pricing; rather we have pushed
ourselves to mere contract mechanics and Shariah rulings.
No doubt during last three to ten years, Islamic finance has grown
with immense pace. It may be due to petro dollars controlled by the
Muslim states or on account of renaissance of Islamic thoughts, but
the fact is that re-emergence of Islamic finance is different from
what was happening hundred or two hundred years back. This
needs to be examined a fresh with new ideas based on principles
laid down in Quran, sunnah and thoughts provided on fiqh by Imam
A'zam Abu Hanifa, Imam Maalik, Imam Shaafi and Imam Ahmed bin
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162
Hambal and other scholars in combination with current financial
norms and practices.
Like any system Islamic finance or Islamic banking has its supporters
as well as critiques. Hence, for moving forward, strength needs to
be drawn from its supporters and lessons from its critiques.
Starting from its base, the main charge leveled on current Islamic
banking or finance is that Islamic banking cannot be implemented
till an Islamic state come in to form. Ideally it looks fine but
practically it is not possible. To reach upon to that target some
transitory arrangements have to be made. Justice Wajihuddin in his
observations in Shariat bench ruling of 2000 has asked for these
arrangements to be swift but not abrupt. Further it needs to be
realized that these changes are already taking place, however, one
can differ on pace that is very slow. In fact arbitrage of Islamic and
conventional systems are now moving towards convergence in form
of realization that social order and equity is the prime target to be
in front of everyone.
The basic objective of Islam is against anything that oppresses
people and in this way interest (Riba) comes in its way that has
many ways of exploiting others, namely the depositors and
borrowers. Also, profitability is not seen as the soul target for
performing business in Islam. Rather Islamic banking is responsible
for social objectives, such as equal distribution of wealth. Social
goals are not to be ignored in any part of Islam and this should be
the basis of Islamic banking.
As stated above Islam treat Riba as a tool of exploitation so its
definition becomes important to design Islamic social system. For
example, some time it is argued that current Islamic banking is
based on a limited concept of Riba or interest that allows rent on
assets providing a basis to Mudarbah contract, the very basis of
current Islamic banking. According to these arguments rent
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163
tantamounts to excess on principal in form of money or other
assets. Since in Quaranic verses, the excess is not permissible so as
per these arguments, rent comes under the definition of interest
and thus bringing in to structure of whole Islamic banking under
question.
Riba has been discussed at 20 places in Quran. However there is a
difference in approach in understanding Riba in its strict sense.
These approaches have been elaborated in the Supreme Court
(Shariat appellate Jurisdiction) judgment 2000. According to this:
One school of thought says that the verses of Quran which
prohibit Riba were revealed in the last days of Holy Prophet
and he could not have time to interpret them properly,
hence no hard and fast definition can be found in Quran and
Sunnah. According to this approach the prohibition of Riba
should be restricted to the limited transactions expressly
mentioned in the Hadith and the principle cannot be
extended to the modern banking system which was not
imaginable at that time.
Second approach says that Riba only refers to the Usurious
(personal) loans on which excessive rate of interest is used
to be charged by the creditors which tends towards
exploitation. As for modern banking interest, it cannot be
termed as Riba if the rate of interest is not excessive or
exploitative.
Third approach says that differentiation should be made
between consumption loans and commercial loans. Since
consumptions loans( mostly consumed by the poor people)
tend towards exploitation so they come under the definition
of Riba but commercial loans used for commercial or
productive purposes do not come under the definition of
Riba.
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164
Fourth approach says that Quran has prohibited Riba al
jahlia. This was a particular transaction of loan where no
additional amount over and above the principal was
stipulated in the agreement of the loan. According to this
theory if an increased amount is stipulated in the initial
agreement of loan it does not constitute Riba-ul-Quran;
however it does fall in the definition of Riba al Fadl
prohibited by Sunnah.
However, after listening these arguments Shariat appellate court
gave its verdict as “any additional amount over the principal in a
contract of loan or debt is the Riba prohibited by the Holy Quran”.
Further to this following transactions were also termed as Riba as
per Sunnah (1) a transaction of money of the same denominations
where the quantity of both sides is not equal either in a spot
transaction or in a transaction based on deferred payment (2) A
barter transaction between two weighable or measurable
commodities of the same kind where the quantity on both sides is
not equal, or where the delivery from one side is deferred. (3) A
barter transaction between two different weighable or measureable
commodities where delivery from one side is deferred.
According to verse Al-Baqrah 2:278-79, any excess
compensation over and above the principal without due
consideration has been termed as Riba. However in the
same verse it has been further said “Those who benefit from
interest shall be raised like those who have been driven to
madness by the touch of the devil: this is because they say;
“trade is like interest” while God has permitted trade and
forbidden interest”. So it is very much clear that if
transactions are backed by trading activities than excess
earned through this mean is not Riba.
Four imams viz: Imam A'zam Abu-Hanifa, Imam Maalik, Imam Shaafi
and Imam Ahmed-bin-Hambal are very close in defining Riba,
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165
however they technically vary. The Hanafi says that Riba is the extra
or the increment of wealth without any return in the exchange of
wealth according to Shariah legal measurement. The Hamblis says
that Riba is a contract which is the extra or the increment of
something which is defined according to legal Shariah and legal
measurement. The Shaafi and Malaki say that Riba is a contract
which is without equal return or something defined according to
shariah legal measurement during the contract or with lapse of time
in exchange.
As explained above, Riba in Pakistan has been defined strictly as any
excess which is predetermined over the principal sum in a loan
transaction. In Iran the Riba is defined as receipt of any extra
amount in excess of principal amount of loan if and only if such
receipt has been preconditioned. The preconditions are
 Existence of indebtedness i.e. if in any deal the factor of
indebtedness is avoided than the receipt of any extra amount
will not be considered as Riba.
 Existence of debtor independence from creditor i.e. in Iran it
is presumed that if lender and borrowers are not independent
and interdependent like son and father or central bank and
government than receipt of any extra amount on principal will
not bring it under Riba definition. Taking advantage of this,
the problem of public debt and statuary reserves have been
solved in Iran.
 Existence of a precondition i.e. if a condition for receipt of
extra amount is not included in the lending agreement
evidently, nothing is payable. However, if in the absence of
that condition any amount in excess of principal is paid than it
will not be treated as Riba.
In Malaysia they have factored in secondary market trading of debt
and debt based securities by making it possible through Bai-ul-Dayn
that is not permissible under Riba as per most of Shariah Scholars.
Even in Malaysia most of the scholars do not agree with this
permission though this transaction is supported by underlying asset.
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The traditional Muslim Jurists are unanimous on the point that Baiul-Dayn with discount or premium is not allowed in Shariah,
however some Shariah scholars have allowed this kind of sale by
referring ruling of Shaafi School but they also consider this fact that
the Shaafi School of jurists allowed it in cases where debt is sold at
its par value. All this situation transpires that three main groups
exist on definition of Riba in Islamic world: Pakistan, GCC, Sudan
follow one school of thought; Malaysia another; and finally Iran
another based on their Fiqh where only Quranic definition of Riba is
considered as important. These are technical deviations but matter
a lot in case of their applications.
Now coming back to the argument of treating rent as un-Islamic
only by saying that it is not supported by Quran or Hadith even on
the basis of depreciation. This does not hold any merit. Islam and
teachings of Quran are against exploitations and if this analogy is
followed than it would be an exploitative act against lessor in case
of renting contract. By definition rent means:1. Payment, usually of an amount fixed by contract, made by a
tenant at specified intervals in return for the right to occupy
or use the property of another.
2. A similar payment made for the use of a facility, equipment,
or service provided by another.
3. The return derived from cultivated or improved land after
deduction of all production costs.
4. The revenue yielded by a piece of land in excess of that
yielded by the poorest or least favorably located land under
equal market conditions. Also called economic rent.
Ricardo, the main architect of rent theory on the conventional side
says that rent is “the difference between the produce obtained by
the employment of two equal quantities of capital and labor." The
model for this theory basically said that while only one grade of land
is being used for cultivation, rent will not exist, but when multiple
grades of land are being utilized, rent will be charged on the higher
grades and will increase with the ascension of the grade. As such,
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167
Ricardo believed that the process of economic development, which
increased land utilization and eventually led to the cultivation of
poorer land, benefited first and foremost the landowners because
they would receive the rent payments either in money or in
product. Thus, in a way Ricardo has supported existence of some
element of exploitation in rent process. How that can be checked
requires land reforms or some other steps.
Commenting on Ricardo definition, SM Yusuf an Islamic Jurists, have
said that in early Islam there was a definite tendency to ordain the
future development of agriculture in such a way that there is no
charge for the use of what Ricardo in his own definition of rent
called original and indestructible power of land.
Parallel to these thoughts Islamic jurists have a consensus on
illegitimacy of interest charged on money loans but on owners right
to income from his property in form of rent and profit they have
difference of opinion. Abu Suleiman (a scholar who wrote theses on
the subject in 1960 and 1973) allows profit sharing but the share of
the capital is only to compensate him from probable loss. He does
not allow net pure profit in this case. Contrary to this, other jurists
endorse the unanimous verdict of all the four principal schools of
Islamic law that the two parties to the mudarbah contract are free
to agree on any formula of sharing the profits provided these shares
are fixed percentage wise and not in the form of given amounts.
Abu Suleiman view point is also somewhat shaky as he failed to
account for that an entrepreneur decision is involved in selecting
the right party in the Mudarbah. Further he also did not provide
support to his views by any precedents from the Sunnah and did not
give any argument against the unanimous verdict of fiqh. Further
there is a general consensus among shariah scholars that in
Mudrabah, the basis of modern Islamic banking, there is no
stipulated ceiling on the percentage share of capital in profit.
However on money rent on cultivable land a distinction has to be
made between plain land in its natural form in which the owner has
not invested any labor or capital to effect improvement and
improved land. There is no dispute that money rent is valid in case
of latter in lieu of depreciation. Tahafi, a jurist finds that there are
authentic traditions from the Prophet both allowing and prohibiting
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168
money rent on land. He is of the view that it depends on different
conditions.
Basically depreciation is a shelter from tax that one has to pay when
he sells it or during the period of his ownership or arises due to its
wear and tear. So these obligations are quite measurable. However
it is also argued that most of the time property tends towards
appreciation on the basis of its demand and supply. In current
complex world, different factors play their role in mark to market
valuation of any asset class. Moreover, if one may accept that rent
is tantamount to excess on principal and is not permissible than in
fact he is denying the valuation concept of any property which has
never been desired by the Islamic system of economy.
It is now very much clear that rental contracts are allowed in Islam if
designed in line with due consideration i.e. tending towards
business, productive activities and increase in wealth with its
improvement and does not have any exploitative posture. This
should be the basis for Mudarbah contracts making base line for
Islamic banking. The dogmatic position that rent should be
prohibited as it is like interest is not tenable economically in this
world. It would have been better if proponents of this view point
have also provided some alternate in case they are refuting
something.
However the perception of functioning of Islamic banks like a
conventional bank culminates from some other aspects. Like they
are managing their liabilities on P/L sharing basis whereas their
assets built up are mostly debt based i.e. Murhabah, Salam or
Istisna. Further their P/L arrangements are being done by using
benchmarks in the conventional market as they have constraints of
competing with their conventional counterparts. These are the
issues that should be looked upon by the government and
regulators.
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169
Chapter 12
ISLAMIC MODES OF FINANCING
The most important characteristics of Islamic financing is that it is
an asset backed financing. The conventional/capitalist concept of
financing is that the banks and financial institutions deal in money
and monetary papers only.
The real and ideal instruments or financing in Sharia are
MUSHARAKAH and MUDARABAH. When a financier contributes
money on the basis of these two instruments it is bound to be
converted in to the assets having intrinsic utility.
Financing on the basis of SALAM and ISTISNA also create real assets.
Financial lease and MURABAHAH mode of financing are although
controversial to some extent and are allowed with certain
conditions but still they hold assets on their backing.
MUSHARAKAH
a) It is a word of Arabic origin, which literally means sharing. In
the context of business and trade it means a joint enterprise
in which all the partners share the profit or loss of the joint
venture. However in this context the term SHIRKAH is more
commonly used in Islamic jurisprudence.
SHIRKAH means sharing and in the terminology of Islamic fiqah it
has been divided in to two kinds.
1.
SHIRKATUL MILK.
It means joint ownership of two or
more persons in a particular property. It may come in to existence
in different ways. One way is that it comes in to being at the options
of parties and another way is that it comes automatically or
compulsorily, for instance in the case of a death of a person.
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2.
SHIRKATUL AQD.
This is second type of SHIRKAH,
which means a partnership effected by a mutual contract. It is
further divided in to three kinds.
 SHIRKATUL AMWAL. In this all partners invests some
capital in to a commercial enterprise.
 SHIRKATUL AMAL.
In this all partners jointly undertake
to render some services for their customers and the fee
charged from them is distributed among them according to
an agreed ratio.
This is also called SHIRKATUL TAQABBUL, SHIRKATUS SANAI
or SHIRKATUL ABDAN.
 SHIRKATUL WUJOOH. In this the partners have no
investment at all. All they do is that they purchase the
commodities on a deferred price and sell them at spot. The
profit so earned is distributed amongst them at an agreed
ratio.

All these modes of financing are termed as SHIRKAH in the Islamic
Fiqah where as the term MUSHARAKH has just been introduced and
normally covers financing under SHIRKATUL AMWAL where as
exceptionally it also includes financing under SHRIKATUL AMAL.
MUSHARAKAH or SHIRKATUL AMWAL is a relationship established
by the parties through a mutual contract, which must carry
necessary ingredients of a valid contract. However in relation to
necessary ingredients MUSHARAKAH carries certain peculiarities
which are summarized as under.
1.
2.
3.
The proportion of profit must be agreed upon at the time of
affecting the contract.
Ratio of profit for each partner must be determined in
proportion to the actual profit accrued to the business and
not in proportion to the capital invested by them.
However in regard to ratio of profit Imam Shafi and Imam
Malik hold that each partner should get the profit exactly in
proportion of their investment., where as Imam Ahmed
holds that ratio of profit may differ from ratio of investment
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4.
5.
6.
7.
171
if it is agreed between the partners with their free consent.
The third view comes from Imam Hanifa according to which
the ratio of profit may differ from the ratio of investment in
normal conditions. However in case of sleeping partner his
share of profit can not be more than the ratio of his
investment.
In the case of loss all Muslim jurists are unanimous on the
point that each partner should suffer the loss exactly
according to the ratio of investment.
It is almost consensus among most of Muslim scholars that
the capital invested by the partners must be in liquid form.
However on the issue of capital investment in
MUSHARAKAH Imam Malik is of the view that the liquidity
of the capital is not a condition for the validity of
MUSHARAKAH therefore it is permissible that a partner
contributes to the MUSHARAKAH in kind but his share shall
be determined on the then basis of evaluation according to
the market price prevalent on the date of contract.
Contrarily Imam Abu Hanifa and Imam Ahmed are of the
view that no contribution in kind is acceptable in a
MUSHARAKAH. Their viewpoint was based on tow
assumptions i-e the commodities are distinguishable from
each other where as value in monetary form is not
distinguishable and forms equitable basis for
MUSHARAKAH. Secondly situation can arise where the
partners have to resort to redistribution of the share capital
which is immensely difficult in case of capital in commodity
form. Imam Shafi holds third view in the matter. He says
that commodities exist in two forms. One is DHAWATULAMTHAL i-e the commodities if destroyed can be
compensated. It includes rice, wheat etc. Second one is
DHAWATUL_QEEMAH i-e the commodities which can not
be compensated by the similar commodities, like cattle.
From this segregation conclusion was drawn that
MUSHARAKAH was permissible under DAWATUL-AMTHAL
but not under DAWATUL-QEEMAH.
The normal principle of management of MUSHARAKAH is
that every partner has the right to take part in its
management. However in case of a sleeping partner he is
not entitled to get profit above to the proportion of his
172
Islamic Economics
8.
9.
investment. Further in case of joint ventures all the partners
will be treated as agents of each other.
In case MUSHARAKA is terminated on due notice from
partner the assets will be redistributed pro rata on
liquidation. In case of non liquidation the distribution will
take place as per agreement and in case of any dispute
where some one wants liquidation and others are not in
favor of it the view point of later will stand. However if the
assets are such that they can not be separated such as
machinery they shall be sold and proceeds will be
distributed. In case of death of any partner the contract of
MUSHARAKAH will stand terminated. However it is at the
option of heirs to continue with the business or to withdraw
its share. In case of insanity or incapability of any partner
the MUSHARAKAH stands terminated.
If one of the partners wants termination of MUSHARAKAH
and the others want to continue, then it can be continued
agreed with mutual consent. However in case of dispute
there seems no bar in Shariah that majority, if wants to
continue the business may prevail.
MUDARABAH
It is a special kind of partnership where one partner gives money to
another for investing it in a commercial enterprise. The investment
comes from the first partner who is called RABBUL MAL while the
management and work is an exclusive responsibility of the other
that is called MUDARIB.
DIFFERENCE BETWEEN MUSHARAKAH AND
MUDARABAH
MUSHARAKAH
MUDARABAH
Investment comes from all Investment
is
the
sole
partners
responsibility of RABBUL MAL.
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Islamic Economics
ALL
the
partners
can The RABBUL MAL has no right to
participate in management
participate in the management
and it is carried out by the
MUDARIB
All partners share loss to the Only RABBUL MAL shares the
extent of ratio of their loss. However this principle is
investment
subject to the condition that the
MUDARIB has worked with due
diligence
The liability is unlimited and in
case of excess liabilities over
assets the difference amount
has to be borne by the partners
as per pro rata. Exceptionally if
any partner has drawn any
debt alone then in that case
the amount is to be paid by him
Liability of RUBBUL MAL is
limited to his investment unless
he has permitted the MUUDARIB
to incur debts on his behalf
As soon the capital is mixed up
in a pool all the partners will
get benefit of its revaluation
even if profit has not been
accrued
MUDARIB can earn his share in
profit only in case of profit and
he has no claim over the
revaluation price
MUDARABAH is of two kinds
One is AL MUDARABAH AL MUQAYADDAH (Restricted
MUDARABAH). In this form the RABBUL MAL may specify the
particular business for the MUDARIB.
Other one is AL MUDARABAH AL MUTLAQAH (Unrestricted
MUDARABAH). In this from it is open for the MUDARIB to
undertake whatever business he likes.
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174
Distribution of profit in MUDARABAH takes place as per agreed
proportion of the actual profit. However in regards to any
remuneration to the MUDARIB other than this Muslim Scholars
have different opinions. Imam Ahmed has only allowed daily
allowance of food to the MUDARIB from the MUDARABAH
accounts. The Hanafi jurists restrict this right to a case when
MUDARIB is on a foreign trip.
The contract of MUDARABAH can be terminated at any time by
either of the two parties and all the assets will be distributed as per
consented agreement. On question of minimum or maximum
period for termination the Shariah provides that it can be arranged
with the mutual consent.
APLICATION OF MUSHARAKAH AND MUDARABAH
ON PRESENT TIME BUSINESS
ESSENTIAL INGREDIENTS
1. Financing through MUSHARAKAH and MUDARABAH does never
mean the advancing of money. It means participation in the
business.
2. An investor must share the loss incurred by the business to the
extent of his financing.
3. The partners are at liability to determine the ratio of their
profit. However the partner who has expressly excluded
himself from the responsibility of work cannot claim more than
the ratio of his investment.
4. The loss shall be borne equal to the proportion of the
investment.
PROJECT FINANCING
In this the traditional method of MUSHARAKAH and MUDARABAH
can be adopted. If the financier wants to finance the whole project
the form of MUDARABAH can be adopted and in case the
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investment comes from both the sides the form of MUSHARAKAH
can be adopted.
SECURITIZATION OF MUSHARAKAH
MUSHARAKAH is a mode of financing which can be securitized easily
especially in the case of big projects where huge amounts are
required which a limited number of people can not subscribe. Every
subscriber can be given a MUSHARAKAH certificate which
represents his proportionate ownership in the assets of the
MUSHARAKAH and after the project is started by acquiring
substantial not liquid assets. These MUSHARAKAH certificates can
be treated as negotiable instruments and can be bought and sold in
the secondary market. However trading in these certificates is not
allowed when all the assets of the MUSHARAKAH are still in liquid
form.
FINANCING OF A SINGLE TRANSACTION
MUSHARAKAH and MUDARABAH can be used more easily for
financing a single transaction. Apart from fulfilling day to day needs
of small traders these instruments can be employed for financing
imports and exports. An importer can approach a financier to
finance him for that single transaction of import alone on the basis
of MUSHARAKAH and MUDARABAH. The banks can also use these
instruments for import financing. If the L/C has been opened
without any margin the form of MUDARABAH can be adopted and if
the L/c is opened with some margin the form of MUSHARAKAH or
combination of both will be relevant. After the imported goods are
cleared from the port their sale proceeds may be shared by the
importer and the financier according to a pre agreed ratio.
In the case of exports the price on which the goods will be exported
is well known and the financier can calculate profit before hand and
accordingly finance on the basis of MUSHARAKAH or MUDARABAH
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and may share the amount of export bill on a prearranged
percentage.
FINANCING OF THE WORKING CAPITAL
Where finances are required for the working capital of a running
business the instrument of MUSHARAKAH may be used as under:
1. The capital of running business may be evaluated with the
mutual consent and accordingly it can be shared upon.
2. Indirect expenses like depreciation of the machinery,
salaries of the staff may be settled by releasing gross profit
to the investors who may borne the indirect expenses
voluntarily where as direct expenses like raw material,
direct labor involved in the processing of raw material,
electricity consumed in processing may be borne by the
MUSHARAKAH.
3. In case where financial institutions finance the working
capital by opening a running account from where the clients
draw/deposit amount at different intervals and the interest
in calculated on product basis MUSHARAKAH and
MUDARABAH financing can be arranged as under:a. A certain percentage of the actual profit must be allocated
for the management.
b. The remaining percentage of profit must be allocated for
the investors.
c. The loss if any should be borne by the investors only in
exact proportion of their respective investments.
d. The average balance of the contributions made to the
MUSHARAKAH account calculated on the basis of daily
products shall be treated as the share capital of the
financier.
e. The profit accruing at the end of the term shall be
calculated on daily product basis and shall be distributed
accordingly
DIMINISHING MUSHARAKAH
it is a developed form of
MUSHARAKAH and according to this concept a financier and his
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177
client participate either in joint ownership of a property or
equipment or in a joint commercial enterprise. The share of the
financier is further divided in to a number of units and it is
understood that the client will purchase the units of the shares of
the financier one by one periodically thus increasing his own share
till all the units of the financier are purchased by him so as to make
him the sole owner of the property or the commercial enterprise as
the case may be.
DIMINISHING MUSHARAKAH IN USE OF HOUSE FINANCING
In house financing it can be arranged as under:1.
2.
3.
4.
5.
Creating joint ownership in the property
Giving share of the financier to the client on rent
Getting promise from the client to purchase the units of
share of the financier.
Actual purchase of the units at different stages.
Adjustment of the rent according to the remaining
share of the financier in the property.
DIMINISHING MUSHARAKAH IN USE FOR BUSINESS OF SERVICES
It is a joint purchase of a taxi or likewise articles used for earning
income by using it as a hired vehicle with given ingredients.
1.
2.
3.
Creating joint ownership
MUSHARAKAH in the income generated through the
services of the taxi
Purchase of different units of the share of financier by
the client.
DIMINSHING MUSHARAKAH IN USE OF TRADE
It can be done by arranging financier contribution in some
percentage of capital for launching a business with given
ingredients.
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1.
2.
178
In the first place the arrangement is simply a
MUSHARAKAH.
Secondly it has to be arranged where purchase of
different units of the share of the financier may take
place by the c
MURABAHA
It is in fact a term of Islamic fiqh and it refers to a particular kind of
sale having nothing to do with financing in its original sense. If a
seller agrees with his purchaser to provide him a specific commodity
on a certain profit added to his cost it is called a MURABAHAA
transaction. The basic ingredient of MURABAHAH is that the seller
discloses the actual cost he has incurred in acquiring the commodity
and then ads some profit thereon. This profit may be in lump sum
or may be based on a percentage. The payment in the case of
MURABAHAH may be at spot and may be on a subsequent date
agreed upon by the parties.
In regard to sale Shariah has defined it as the exchange of a thing of
value by another thing of value with mutual consent. However it
must qualify given conditions:
1.
2.
3.
4.
5.
6.
7.
8.
Subject of sale must be existing at the time the time of
sale.
Subject of sale must be in the ownership of the seller at
the time of sale.
Subject of sale must be in physical or constructive
possession of the seller when he sells it to another
person.
The sale must be instant and absolute.
The subject of sale must be a property of value.
The subject of sale should not be the thing, which is not
used except for a haram purpose.
The subject of sale must be specifically known and
identified to the buyer
The delivery of the sold commodity to the buyer must
be certain and should not depend on a contingency or
chance.
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9.
10.
179
The certainty of price is a necessary condition for the
validity of a sale.
The sale must be unconditional.
The peculiarities of MURABAHA can be stated as under
1. MURABAHAH is a kind of sale where the seller expressly
mentions the cost of the sold commodity he has incurred
and sells it to another person by adding some profit or mark
up thereon.
2. The profit of MURABAHA can be determined by mutual
consent.
3. All the expenses incurred by the seller in acquiring the
commodity like freight, custom duty shall be included in the
cost price and the mark up can be applied on the aggregate
price.
4. MURABAHA is valid only where the exact cost of a
commodity can be ascertained.
BASIC FEATURES OF MURABAHA FINANCING
1. It is not a loan on given interest. It is the sale of a
commodity for a deferred price, which includes an agreed
profit, added to the cost.
2. Being a sale and not a loan the MURABAHA should fulfill all
the conditions necessary for a valid sale.
3. It can not be used as mode of financing except where the
client needs funds to actually purchase some commodities.
4. The financier must have owned the commodity before he
sells it to his client.
5. The commodity must come in to possession of financier
whether physical or constructive.
6. The best way in the case is that the financier himself
purchase the commodity and keeps it in his own possession
or purchases the commodity through a third person
appointed by him as agent before he sells it to the
customer. However exceptionally where direct purchase
from the supplier is not practicable for some reasons it is
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180
allowed that he makes the customer himself his agent to
buy the commodity on his behalf.
In the light of aforementioned rules the financial institutions can
use the MURHABHA as mode of financing by going through stages
as under:





The client and the institution sign an overall agreement
where by the institution promises to sell and the client
promises to buy the commodities from time to time on
an agreed ratio of profit added to the cost.
When a specific commodity is required by the
customer, the institution appoints the client as his
agent for purchasing the commodity on its behalf and
agreement of agency is signed by both the parties.
The client purchases the commodity on behalf of the
institution and takes its possession as an agent of the
institution.
The client informs the institution that he has purchased
the commodity on his behalf and at the same time
makes an offer to purchase it from the institution.
The institution accepts the offer and the sale is
concluded whereby by the ownership as well as the risk
of the commodity is transferred to the client.
BAI MUAJJAL
It is a sale in which the parties agree that the payment of price shall
be deferred is called a BAI MUAJJAL. It contains given ingredients.
1.
2.
3.
It is valid if the due date of payment is fixed in
unambiguous manner.
The due time of payment can be fixed either with
reference to a particular date or by specifying a period
but it can not be fixed with reference to a future event.
If a period is fixed for payment it will be deemed to
commence from the time of delivery unless agreed
otherwise.
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4.
5.
6.
7.
181
The deferred price must be more than cash price but
must be fixed at the time of sale.
Once the price fixed can not be changed either in case
of earlier payment or default.
In order to pay the installments in time the buyer may
be asked to pay some additional amount as donation in
case of default, which will be donated to some
charitable institutions or in other case his all remaining
installments will become due immediately.
To secure the payment of price by the buyer may
furnish security either in form of mortgage or lien
marked on some assets as security. The buyer can also
be asked to sign a Promissory Note or Bill of Exchange,
which can be given to a third party at par value.
IJARAH
It is a term of Islamic Fiqh. It means to something on rent
In Islamic jurisprudence the word Ijarah is used for two different
situations.
In the first place it means to employ the services of a person on
wages given to him as consideration for his hired services. The
employer is called MUSTAJIR while the employee is called AJIR.
The second type of IJARAH relates to the usufruct of assets and
properties and not the services of human beings. IJARAH in this
sense means to transfer the usufruct of a particular property to
another person in exchange for a rent claimed from him. In this case
the word IJARAH is analogous to the English term LEASING. Here the
lessor is called MUJIR, the lessee is called MUSTAJIR and the rent
payable to the lessor is called UJRAH.
The rules of IJARAH in the sense of leasing are very much analogous
to the rules of sale because in both cases something is transferred
to another person for a valuable consideration. The only difference
between IJARAH and sale is that in the latter case the corpus of the
property is transferred to the purchaser while in the case of IJARAH
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the corpus of the property remains in the ownership of the
transferor but only its usufruct i.e. the right to use it is transferred
to the lessee. Therefore it can easily be seen that IJARAH is not a
mode of financing in its origin and can be termed a normal business
activity like sale. However when used for financing purpose it has to
be governed by certain rules, which are as under:









It is a contract where by the owner of something transfers
its usufruct to another person for an agreed period at an
agreed consideration.
The subject of lease must have a valuable use.
It is necessary for a valid contract of lease that the corpus of
the leased property remains in the ownership of the seller
and only its usufruct is transferred to the lessee.
As the corpus of the leased property remains in the
ownership of the lessor all the liabilities emerging from the
ownership shall be borne by the lessor but the liabilities
referable to the use of the property shall be borne by the
lessee.
The period of lease must be determined in clear terms.
The lessee can no t use the lease asset for any purpose
other than the purpose specified in the lease agreement. If
no such purpose is specified in the agreement the lessee
can use it for whatever purpose it is used in the normal
course.
The lessee is liable to compensate the lessor for every harm
to leased asset caused by any misuse or negligence on the
part of the lessee.
The leased asset shall remain in the risk of the lessor
through out the leased period in the sense that any harm or
loss caused by the factors beyond the control of the lessee
shall be borne by the lessor.
A property jointly owned by two or more persons can be
leased out and the rental shall be distributed between all
the joint owners according to the proportion of their
respective shares in the property.
A joint owner of a property can lease his proportionate
share to his co sharer only and not to any one other person.
Islamic Economics







183
It is necessary for a valid lease that the leased asset is fully
identified by the parties.
The rental must be determined at the time of contract for
the whole period of lease. It is permissible that different
amounts of rent are fixed for different phases during the
lease period provided that the amount of rent for each
phase is specifically agreed upon at the time of affecting a
lease.
The determination of rental on the basis of the aggregate
cost incurred in the purchase of the asset by the lessor as
normally done in financial lease is permissible.
The lessor can not increase the rent unilaterally and any
agreement to this effect is void.
The rent on any part thereof may be payable in advance
before the delivery of the asset to the lessee, but the
amount so collected by the lessor shall be adjusted towards
the rent after its being due.
The lease period shall commence from the date on which
the leased asset has been delivered to the lessee, no mater
whether the lessee has started using it or not.
If the leased asset has totally lost the function for which it
was leased and no repair is possible the lease shall
terminate on the day on which such loss has been caused.
In financing under IJARAH one should keep in mind that there is a
difference between the contemporary leasing and the actual leasing
allowed by the SHARIAH. These differences are indicated as under:1. Unlike the contract of sale the agreement of IJARAH can be
effected for a future date. Thus while a forward sale is not
allowed in SHARIAH an IJRAH for a future date is allowed on
the condition that the rent will be payable only after the
leased asset delivered to the lessee.
2. It should be clearly understood that when the lessee himself
has been entrusted with the purchase of the asset intended
to be leased there are two separate relations between the
institutions and the client which come in to operation one
after the other. In the first instance the client is an agent of
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184
the institution to purchase the asset on latter’s behalf. At
this stage the relation between the parties is nothing more
than the relation of a principal and his agent. The relation of
lessor and lessee has not yet come in to operation. The
second stage begins from the date when the client takes the
delivery from the supplier. At this stage the relation of
lessor and lessee comes to play its role. These two
capacities of the parties should not be mixed up or confused
with each other. During the first stage the client can not be
held for the obligations of a lessee. In this period he is
responsible to carry out the functions of an agent only. But
when the asset is delivered to him he is liable to discharge
his obligations as a lessee.
3. As the lesser is the owner of the asset and he has purchased
it from the supplier through his agent, he is liable to pay all
expenses incurred in the process of its purchase and its
import to the country of the lessor. Consequently he is
liable to pay all the freight and the custom duties etc.
4. As per basic principle of the leasing lessee is responsible for
any loss caused to the asset by his misuse and negligence.
5. In the long term lease agreements the lessor can avail
options as under in view of market fluctuations.


He can contract a lease with conditions that the
rent shall be increased according to a specified
proportion after a specified period.
He can contract lease for a shorter period after
which lease can be renewed with new terms and
conditions.
6. If the lessee contravenes any terms of the agreement the
lessor has right to terminate the lease contract unilaterally.
However if there is no contravention on the part of the
lessee the lease can not be terminated without mutual
consent.
7. In case of termination of lease even at the option of the
lessor the rent of remaining period sometime stipulated to
be payable by the lessee is not permissible.
8. If the leased property is insured it should be at the expense
of the lessor and not at the expense of the lessee.
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185
9. Original position in SHARIAH is that asset shall be the sole
property of the lessor and after the expiry of the lease
period the lessor shall be at liberty to take the asset back to
renew the lease or to lease it out to another party or to sell
it to the lessee or to any other person. The lessee can not
force him to sell it to him at nominal price not cash such
condition be imposed on the lessor in the lease agreement.
However some contemporary scholars keeping in view the
needs of the financial institutions have come up with an
alternative. They say that the agreement of IJARAH itself
should not contain a condition of gift or sale at the end of
the lease period. However the lessor may enter in to a
unilateral promise to sell the lease asset to the lessee at the
end of the leased period and this promise will be binding on
the lessor only.
10. If the leased agreement is used differently by different users
the lessee can not sub lease the leased asset except with
the express permission of the lessor. If the lessor permits
the lease for subleasing he may sublease it.
11. The lessor can sell the lease property to a third party where
by the relation of lessor and lessee shall be established
between the new owner and the lessee. However the
assigning of lease itself without assigning the ownership in
the leased asset for a monetary consideration is not
permissible.
12. The arrangement of IJARAH has a good potential of
securitization which may create a secondary market for the
financier on the basis of IJARAH. Since the lessor in IJARAH
owns the leased assets he can sell the asset in whole or in
part to a third party who may purchase it and may replace
the seller in the rights and obligations of the lessor with
regard to the purchased part of the asset. Therefore if the
lessor after entering in to IJARAH wishes to recover his cost
of purchase of the asset with a profit thereon he can sell the
leased asset wholly or partly either to one party or to a
number of individuals.
13. Another concept developed in the modern leasing business
is that of head leasing. In this arrangement a lessee
subleases the property to a number of subleases. Then he
invites others to participate in his business by making them
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186
share the rentals received by his sub leases. For making
them participate in receiving rentals he charges a specified
amount from them.
SALAM
It is a sale whereby the seller undertakes to supply some specific
goods to the buyer at a future date in exchange of an advanced
price fully paid at spot. Here the price is cash but the supply of the
purchased goods is deferred. They buyer is called RABBUS SALAM
the seller is MUSLAM ILAIH, the cash price is RAASUL MAL and the
purchased commodity is termed as MUSLAM FIH. SALAM was
allowed by the Holy Prophet subject to certain conditions. The basic
purpose of this sale was to meet the needs of the small farmers who
needed money to grow their crops and to feed their family up to the
time of harvest.
CONDITIONS TO BE OBSERVED
1. First of all it is necessary for the validity of SALAM that the
buyers pay the price in full to the seller at the time of
affecting the sale.
2. SALAM can be effected in those commodities only the
quality and quantity of which can be specified exactly.
3. SALAM can not be effected on a particular commodity or on
a product of a particular field or farm.
4. It is necessary that the quality of the commodity intended
to be purchased through SALAM be fully specified leaving
no ambiguity, which may lead to dispute.
5. It is also necessary that the quantity of the commodity be
agreed upon in unequivocal terms.
6. The exact date and place of delivery must be specified in
the contract.
7. SALAM can not be effected in respect of things, which must
be delivered at spot.
8. It is necessary according to HANAFI School that the
commodity for which SALAM is effected remains available
in the market right from the day of contract up to the date
of delivery. However the other three schools of Fiqh are of
187
Islamic Economics
the view that the availability of the commodity at the time
of the contract is not a condition for the validity of SALAM.
What is necessary according to them is that it should be
available at the time of delivery.
9. As mode of financing it is more suited for the small farmers
and traders attached with agricultural sector.
ISTISNA
ISTISNA is the second kind of sale where a commodity is
transacted before it comes in to existence. It means to order a
manufacturer a specific commodity for the purchaser. If the
manufacturer undertakes to manufacture the goods for him
with the material from the manufacturer, the transaction of
ISTISNA comes in to existence. But it is necessary for the validity
of ISTISNA that the price is fixed with the consent of the parties
and that necessary specification of the commodity intended to
be manufactured is fully settled between them.
DIFERENCE BETWEEN ISTISNA & SALAM
ISTISNA
SALAM
The subject is always of a No matter whether the thing
thing
which
needs needs manufacturing or not
manufacturing
It is not necessary to pay Necessary to pay the price in
the price in advance
advance
The contract can be The contract once effected can
cancelled
before
the not be cancelled unilaterally
manufacturer starts the
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188
work
Fixation of time of delivery Time of delivery is an essential
is not essential
part.
AS MODE OF FINANCING
ISTISNA can be used in house finance sector, project financing
and in Buy, Operate and Transfer agreements.
ISLAMIC INVESTMENT FUNDS
In the contemporary era there may be certain models in regard
to ISLAMIC INVESTMENT FUNDS. Some of the forms can be
described as under:EQUITY FUNDS
In an equity fund the amounts are invested in the shares of joint
stock companies. The profits are mainly derived through the
capital gains by purchasing the shares and selling them when
the prices are increased. Profits are also earned through
dividends distributed by the relevant companies.
IJARAH FUND
Another type of Islamic Fund may be an IJARAH FUND. In this
fund the subscription amounts are used to purchase assets like
real estate, motor vehicles or other equipment for the purpose
of leasing them out to their users. The ownership of these
assets remains with the fund and the rentals are charged from
the users. These rentals are the source of income for the fund,
which is distributed pro rata to the subscribers.
Each
subscriber is given a certificate to evidence the proportionate
ownership in the leased assets and to ensure his entitlement to
the pro rata share in the income.
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189
COMMODITY FUND
Another type of Islamic Fund may be a commodity Fund. In the
fund of this type the subscription amounts are used in
purchasing different commodities for the purpose of their
resale. The profit generated by the sales are the income of the
fund, which is distributed pro rata among the subscribers.
MURABAHA FUND
MURABAHA is a specific kind of sale where the commodities are
sold on a cost plus mark up basis. In this the banks purchase the
commodity for the benefits of their clients, then sell it to them
on the basis of deferred payment at an agreed margin or profit
added to the cost. If a fund is created to undertake this kind of
sale it should be a closed end fund and its units can not be
negotiable in a secondary market.
BAI AL DAIN
It donates the sale of debt. In this if a person has a debt
receivable from a person and he want to sell it at a discount as
in case of Bill of Exchange. Most of the Scholars are unanimous
on the point that BAI AL DAIN with discount is not allowed.
However Muslim scholars of Malaysia have allowed this kind of
sale and for this they refer the rulings of SHAFITES School
wherein it is held that the sale of debt is allowed.
MIXED FUND
Another type of Islamic Fund may be of a nature where the
subscription amounts are employed in different type of
investments, like equities, leasing, commodities etc. In this case
if the tangible assets of the fund are more than 51% while the
liquidity and debts are less than 50% the units of the funds are
negotiable otherwise not.
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190
Exercises
1. How economics as a social science can be defined. Explain
evolution of the economic thoughts through classical, neo
classical, Keynesian and current thoughts.
2. Explain about segregation of economics in to Micro, Macro,
development and international economics and give some
details about these disciplines.
3. How equilibrium of Supply and demand schedule is arrived
at. Also explain relation of price elasticity of supply and
demand with this equilibrium.
4. What is meant by the marginal utility and how law of
diminishing marginal utility comes in to play? How law of
diminishing marginal utility can be extended in to law of
equi marginal utility.
5. What is meant by Total, Average and Diminishing marginal
returns and how law of Diminishing marginal returns
translates in to economies of scale?
6. What is meant by consumer equilibrium and how it is
arrived at through consumer demand curve?
7. What is meant by Total, Average and Marginal physical
product and how it relates to production functions in its
three stages?
8. Define and explain concepts of Total, Average, Marginal and
Opportunity Cost.
9. How efficiency of competitive market can be defined and
what is meant by Monopoly and oligopoly. How efficiency
can be arrived at under monopolistic competition. Also
explain how marginal revenue works under monopolistic
competition.
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191
10. How Income and Wealth is defined in economics and what
is meant by rate of return. How PV and NPV of a future
value can be arrived a
11. Define Islamic economics by highlighting its main
differences with general economics. Also compare Islamic
financial system with capitalism and Socialism giving at least
two points showing its superiority over these systems.
12. Define Riba explaining Riba-al-Fadal and Riba-ul-nisa. How
Riba is defined in Pak subcontinent/GCC and Sudan in
comparison with its definition in Iran and Malaysia.
13. Give a brief on evolution of Islamic economics distinguishing
between period of Khulfai Rashedeen, Islamic Capitalism
and contemporary period. Also brief about principles laid
down by Ibne Khuldun and Baqr ul Sadar.
14. How principles of Islamic economics can be applied on
disciplines of Micro, Macro, development and International
economics and what in nut shell are its outcome. Briefly
explains.
15. Write a brief on development of Islamic economics in
countries i.e. Iran, Sudan, Malaysia and Pakistan.
16. Define non debt based and debt based financing in Islamic
economics. Which one is superior and why. Also explain the
kind which one is mostly in practice now a day.
17. How fiscal and monetary policy framework can be explained
in Islamic economics. What are the main impediment in
their adoption and how they can be removed?
18. In current global financial crisis what are its main causes and
whether Islamic finance has any answer for its resolution.
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192
Simply explain. Finally how you can differentiate between
securitization in conventional and Islamic economics.
19. Write short notes on
(a) Musharka and Mudarbah
(b) Salam and Istisna
(c) Murahabah
(d) Islamic Funds
(e) Bai muajal
(f) How Gharar (uncertaininty) or speculation is considered
in Islamic economics. In absence of speculation whether
risk on financial transactions can be mitigated and how.
Kindly explain.
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193
Bibliography
1. Principles of Money Banking and Financial Markets by
Lawrence S Ritter, William L Silber and Gregory F Udell
2. Investment Banking in the Financial Markets by Charles
R Geesst
3. Investment Banking by Guiliano Iannotta.
4. Islamic Economics by M. Asif Malik
5. Islamic Finance Law, Economics and Practice by
Mahmoud A El Gamal
6. Islamic Asset Management edited by Sohail jaffer
7. Islamic Mode of Financing by Taqi Muhammad Usmani
8. Usury Free banking in Iran by Muhammad Ayub
9. Operations and working of Banks in Sudan by
Muhammad Ashraf Janjua
10. Muslim Economic thinking A Survey of contemporary
literature Muhammad Nejatullah Siddiqui
11. Hedging in Islamic Finance by Sami Al Suwailen
12. The Financial System and monetary policy in an Islamic
economy by Mohsin S Khan and Abbas Mirakhor
13. Various websites specifically of Wikedia
14. Data source for tables and graphic presentations- SBP
and other websites
Islamic Economics
194
Profile about writer
Muhammad Arif has served SBP for more than 30 years. Basically he
remained involved in catering money market activities, interest rate
management and market products development. After leaving SBP in 2007
as Head of Financial markets and Strategy Department, he served as Head
of Research at Arif Habib Investments. Now he is Editor at Large to ‘The
Financial Daily’ a notable English newspaper. Before that he was Research
Consultant of the paper. He also remained member of the visiting faculty
on the subjects of Financial Management/Investment Banking/Islamic
Economics/Derivatives/International-Finance/Treasury
and
Funds
Management/Anti Money Laundering/Risk Management/Investments and
Portfolio Management at Sheikh Zayed Sultan Institute University of
Karachi/KASBIT/Muhammad Ali Jinnah University/PAF KIET and BIZTEK. He
also read many Research Papers at various Universities. During his tenure
of service he also served on deputation to the UN Poverty alleviation group
in Bangkok on development of Fixed Income Market in Pakistan. He also
remained member of Task Force of IFSB, a Malaysian based group of
Islamic countries (authorized by IOC) on development of Islamic Finance.
He also remained member of Investment Committee on Access to Justice
Fund of Supreme Court of Pakistan. He also represented Pakistan in 28
member group formed in Bangkok under Chiang Mai declaration on
development of fixed income Market in these countries. Further to these
he has also represented Pakistan in different forums in other countries on
issues pertaining to development of financial markets in various
jurisdictions particularly on Fixed Income side and Islamic Finance.