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Review of Islamic Economics, No. 13, 2003, pp. 5–21

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Allocative Efficiency of Profit Maximization: An Islamic Perspective *

Ruzita Mohd. Amin and Selamah Abdullah Yusof

Abstract: Profit maximization forms the basic assumption in the theory of the firm. The application of profit maximization has been criticized as inconsistent with Islamic behaviour. However, this paper contends that the principle is valid for an Islamic economic framework, to achieve the desired outcomes of an Islamic economy. In particular, it ensures allocative efficiency, that is, the production of the ‘right’ goods in the ‘right’ amount. This can be achieved if, in the valuation of its opportunity costs, the firm takes into account the nature of the good to be produced, in accordance with Islamic ethical values. A simple theoretical framework is presented to support this proposition. The outcomes in the conventional and Islamic frameworks are compared under both perfectly and imperfectly competitive markets.

I. Introduction

In the Islamic perspective, man assumes the role of vicegerent of Allah, accountable to Him for all his deeds, decisions and the intentions behind them, including the conduct of his economic activities. All resources are treated as a trust and rational decisions are made with regard to their allocation in accordance with the guidelines prescribed by Islam. As stated in the Qur’¥n, ‘O you who believe!

* This is a revision of a paper presented at the Western Economic Association International 76th annual conference, San Francisco, July 6, 2001, in a session organized by Zubair Hasan, International Islamic University, Malaysia. The authors would like to thank Mustafa Omar Muhammad, Mohamed Aslam Haneef, and Zubair Hasan for their comments and suggestions.

RuZITA MOHD. AMIN AND SELAMAH ABDULLAH YUSOF both are Associate Professors at the Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia.

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Betray not the trust of Allah and the Messenger, nor misappropriate knowingly things entrusted to you’ (8:27). The objective of man, who is also an economic agent in an Islamic society, is to achieve well-being (fal¥^) in this world and the hereafter and the approval of Allah (mar\a Allah). Many verses in the Qur’¥n affirm this; for instance ‘But seek, with that [wealth] which Allah has bestowed on you, the home of the hereafter, nor forget your portion in this world: but do good as Allah has been good to you, and do not seek mischief in the land: for Allah loves not those who do mischief’ (28:77). In addition, the Prophet Muhammad (peace be upon him) said:

‘All people are the dependents of Allah, and the most beloved among them are those who are most benevolent to His dependents including those who put His resources to proper use’ (Ibn Kathir, 1980: 287). In an Islamic framework, it is accepted that a firm’s behaviour must be guided by Islamic values and ethics, for that is what distinguishes it as Islamic. Siddiqi (1992: 140), enunciates that the firm should be in full compliance with the Islamic idea of justice and its entrepreneurial decisions should be motivated by service of the society. Production is viewed as a means not only to achieve material satisfaction but also a means to attain goals in the hereafter (Kahf, 1992; Mannan, 1992). In attempts to formalize the behaviour of an Islamic firm in a theoretical framework, some authors have proposed maximizing utility (rather than profit, as is usually assumed in conventional economics) as the distinctly Islamic objective (for example Metwally, 1992; Bendjilali and Taher, 1990; and Hallaq, 1995). Broadly, they state utility as a function of profit and charity/social welfare. The approach varies, however, from one work to another. Metwally (1992) deducts the amount of zak¥h 1 paid by the firm from the profit function, while he treats expenditure on charity as part of the cost function. As a result, he argues that the Islamic firm in this model will produce a higher level of output and at a higher price. Bendjilali and Taher (1990) provide a relatively more elaborate theoretical framework by deriving the condition for an Islamic monopolist to produce a level of output higher than that of a profit-maximizing conventional monopolist. In Hallaq’s model (1995) charity is included to represent the social welfare variable in the utility function.

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However, the outcome for the Islamic firm here is no different from the conventional firm in terms of price and output. In addition, there are several flaws in the formulation and analysis of the model. Other authors, for example Hassan (1983; 1992), have assumed the same objective for the firm as in conventional economics, that is profit maximization. They use this assumption to analyse the rewards to the factors of production and how it affects the cost of production of an Islamic firm. The resulting outcome is higher output with lower prices, as compared to the conventional firm, mainly due to abolition of interest. On the other hand, Siddiqi (1992) has argued that profit could be maximized within Islamic tenets, stressing the attainment of a ‘fair’ or ‘satisfactory’ level of profit. Some of the works just mentioned are conceptual in nature (Kahf, 1992; Mannan, 1992; and Siddiqi, 1992), while others have attempted to provide models that illustrate the Islamic firm’s behaviour. Unfortunately, however, there are inconsistencies in Metwally (1992), Bendjilali and Taher (1990), and Hallaq (1995). 2 In addition, these works have implicitly assumed that higher output must mean higher welfare to the society. This is rather simplistic in that it maintains the conventional assumption that more is always preferrable to less regardless of the type of good produced. Within an Islamic framework that is not necessarily true, since the effect on social welfare will depend on the nature of the good produced. In addition, the pattern of production and allocation of resources must incorporate the following guidelines as mentioned in Siddiqi (1992). Some of these are:

i) Prohibited goods and services are not be produced.

ii) The production of so-called ‘refinement’ goods is small, and accordingly, fewer resources are allocated to their production.

iii) More resources are allocated to the production of so-called ‘necessity’ goods.

This paper will present a simple theoretical model that shows how an Islamic firm will produce these outcomes while still maintaining profit maximization. In this respect, the analysis will focus on firms within an Islamic framework and compare outcomes with those within the conventional framework. In addition, it will

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also analyse the behaviour of Islamic and conventional firms that co- exist in the same economy. From the results, it will be shown that there is an increase in social welfare in terms of meeting the needs of the society if firms behave according to the principles of Islamic Law. The next section (II) articulates some of the concepts that underlie the analysis in this paper. Section III deals with the construction of a theoretical model to formalize the issues discussed, and the last section (IV) presents some policy implications of the model and the conclusion.

II. Some Underlying Concepts

One of the main goals of an Islamic economy is to fulfil the basic needs of food, clothing, shelter, medical care and education for all human beings (Siddiqi, 1992: 4). The allocation of resources to achieve this purpose is guided by the SharÏ¢ah, which promotes Ma|¥li^ al-¢Ib¥d (the welfare of human beings). Ma|la^ah is that which is beneficial or promotes welfare (Wehr, 1961: 522). According to al-Ghaz¥lÏ and later al-Sh¥tibÏ, social welfare may be promoted through a three-level hierarchy of activities or goods, namely, in order, ‘necessities’ (dar‰rÏy¥t), ‘conveniences’ (^¥jiy¥t), and ‘refinements’ (ta^sÏniy¥t) (Ibn ¢®sh‰r, 1998: 210). ‘Necessities’ comprise all activities and goods that are essential to the preservation of the five foundations of good individual and collective life, according to Islam, namely religion (al-dÏn), life (al- nafs), mind (al-¢aql), offspring (al-nasl) and wealth (al-m¥l). ‘Conveniences’ are all activities and goods that are not vital to the preservation of the five foundations, but are needed to relieve or remove impediments and difficulties in life. ‘Refinements’ include activities and goods that go beyond the limit of conveniences, they serve to brighten, complement or adorn life (Zarqa, 1989: 34-6). A Muslim is religiously motivated to acquire or produce such goods and services as have ma|la^ah. Some goods and services will have more, others less, ma|la^ah, depending on their position in the hierarchy (Khan, 1992: 73-4). Therefore, necessities will have higher ma|la^ah, followed by conveniences and finally by refinements, assuming that the necessities are not yet fully met. In the Islamic framework, it is assumed that economic agents are guided by Islamic values. Thus, an Islamic producer, being

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accountable to Allah, treats the resources at his command as a trust and the production of goods as a duty, and he will base his production decisions on the concept of ma|la^ah. He can still be profit-driven but, being governed by the SharÏ¢ah, the Islamic producer’s valuation of economic costs will be modified. Costs exist because resources are scarce and have alternative uses. For the Islamic producer, the opportunity cost of producing a good (included in the calculation of economic costs), being measured as its value or worth in its best alternative use (McConnell and Brue, 1999), must take into account the nature of the good produced relative to the other alternative goods. Hence, the value of the best alternative good will depend on its position in the hierarchy of goods as stated earlier. For instance, in the production of a necessity good which has a high ma|la^ah (giving high benefit or value to the society), where its best alternative is to produce a refinement good which has a relatively lower ma|la^ah (giving lower benefit or value to the society), the opportunity cost of producing the necessity good will be lower. Conversely, in the production of a refinement good of which the next best alternative is a necessity, the opportunity cost of producing the refinement good will be higher. 4 Clearly, the goods considered here are only goods that are ^al¥l (permissible). In the case of ^ar¥m (prohibited) goods, the opportunity cost will be prohibitively high, which means that they will never be produced by an Islamic firm. Thus, the valuation of opportunity cost for a particular good will be different under the Islamic framework than the conventional one. It will either be lower or higher, depending on the nature of the good to be produced.

III. The Theoretical Model

Let us consider a firm in a conventional framework that sets its price and output at the profit-maximizing level. Profit is usually defined as economic profit, which is the difference between a firm’s total revenue and total costs, including opportunity cost.

Thus, the profit function (π) is defined as follows:

π=π(q)=R(q)−C(q)

(1)

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Review of Islamic Economics, No. 13, 2003

where R is the total revenue, C is the total economic cost, and q is the quantity of output produced and sold.

Total revenue (R) is given as:

R(q)=P(q).(q)

(2)

where P is the price, and total economic cost (C) is:

C=E(q)+I c (q)

(3)

where E(q) is the explicit cost, and I c (q) is the implicit/opportunity cost.

The standard first-order condition for profit maximization applies where marginal revenue is equal to marginal cost.

The above would also hold for a firm in an Islamic framework. However, the calculation of opportunity cost would need to take into consideration the nature of the good produced by the firm, relative to other alternative goods. Thus, for simplification purposes, the implicit/opportunity cost under the two frameworks will be as follows:

Conventional implicit/opportunity cost:

I c =I c (q), where I c (0)=0

Islamic implicit/opportunity cost:

I s =I s (q)=α(q)+I c (q),

(4)

(5)

where α is the Islamic valuation of opportunity cost of the good based on ma|la^ah, and α (0)=0.

For the production of a necessity good when the best alternative is a refinement good, for α’(q)<0 for q>0 (since the higher is the production of the necessity good, the higher the fulfilment of the society’s needs, the smaller will be the opportunity cost associated with its production). 5 On the other hand, for the production of a refinement good when the best alternative is a necessity good, α’(q)>0 for q>0 (since the higher the production of the refinement good, the lower the fulfilment of the society’s needs, the higher will be the opportunity cost associated with its production). 6

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Thus, in the production of the necessity good, I s (q)<I c (q), for all q>0 and therefore, the total cost, average cost and marginal cost for the good will be lower in an Islamic framework than in the conventional framework. This is illustrated in Figure 1, for the case of a firm operating in an imperfect market.

Price MC C AC C (Conventional Framework) P C MC S AC S (Islamic Framework)
Price
MC C
AC C (Conventional Framework)
P C
MC S
AC S (Islamic Framework)
P S
MR
AR=D
*
*
Quantity
q C
q S

Figure 1: Production of Necessity Goods under the Islamic and Conventional Frameworks: The Case of Imperfect Markets

Assuming that the firm faces the same demand function 7 , its profit-maximizing output level will be higher in an Islamic framework

(q * s ) compared to that in the conventional framework (q c * ), and the price level (P s ) will be lower. This means that, under the Islamic framework in this model, more necessity goods will be produced at a lower price which gives higher benefits to the society without the firm having to deviate from its profit-maximizing decision. For the production of a refinement good when the best

alternative is a necessity good, the opposite will hold since I

for all q. The result will be lower output (q * s <q c * ) and higher price

(q)>I c (q),

s

(P s >P c ), under an Islamic framework, as shown in Figure 2. Again, this implies higher benefit to the society since fewer will be allocated

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to the production of such goods, for refinements bring benefit only to a relatively small group of individuals in the society.

Price MC S AC S (Islamic Framework) P S MC C P C AR=D MR
Price
MC S
AC S (Islamic Framework)
P S
MC C
P C
AR=D
MR
*
*
Quantity
q S
q C

Figure 2: Production of Refinement (Luxury) Goods under the Islamic and Conventional Frameworks: The Case of Imperfect Markets

This outcome can also be shown mathematically as follows. The firm’s objective is to maximize profit, where the profit functions are given below for firms operating within the Islamic and conventional frameworks, respectively, based on equations (1), (2) and (3).

Islamic framework:

π(q)=R(q)−[E(q)+I c (q)+α(q)]

Conventional framework:

π(q)=R(q)−[E(q)+I c (q)]

The first-order conditions for profit maximization are:

R’(q * s )=E’(q * s )+I c (q * s )+α(q * s

)

R’(q c * )=E’(q c * )+I c (q c * )

(6)

(7)

(8)

(9)

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where q * s and q c * are the optimal outputs of the firm under the Islamic and conventional frameworks, respectively. It is assumed that marginal revenue is a decreasing function of q. For the case of production of necessity goods, α’(q * s )<0. Therefore, for the first-order conditions to hold, q * s >q c * . Alternatively, for refinement goods, α’(q * s )>0 , thus q * s <q c * . Similar results can also be obtained for both necessity and refinement goods under competitive markets, as shown in Figures 3 and 4. As can be seen, for necessity goods, the total output produced by the industry in the Islamic framework (Q s ) is higher compared to the conventional outcome (Q c ), and price (P s ) is lower in the long- run. This is because more firms will be motivated to enter the industry and produce the necessity goods due to its lower economic cost, and as a result of this, the market supply of these goods in an Islamic framework will be larger, hence pushing the market price lower than in the conventional framework. Note that the individual firm’s output may be the same as that of the conventional firm, as shown in Figure 3. 8 On the other hand, output for refinement goods will be lower (Q s <Q c ) and price higher (P s >P c ) under the Islamic framework compared to the conventional, due to lower market supply. 9

Firm

Price MC C AC C MC S AC S P C MR C =AR C
Price
MC C
AC C
MC S
AC S
P C
MR C =AR C =D C
MR S =AR S =D S
P S
q*
Quantity

Market

Price S C S S P C P S D Quantity Q C Q S
Price
S C
S S
P C
P S
D
Quantity
Q C
Q S

Figure 3: Production of Necessity Goods under Islamic and Conventional Frameworks: The Case of Competitive Markets

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Firm Price MC S AC S MC C AC C P S MR S =AR
Firm
Price
MC S
AC S
MC C
AC C
P S
MR S =AR S =D S
P C
MR C =AR C =D C
q*
Quantity

Market

S S Price S C P S P C D Q S Q C Quantity
S S
Price
S C
P S
P C
D
Q S
Q C
Quantity

Figure 4: Production of Luxury Goods under Islamic and Conventional Frameworks:The Case of Competitive Markets

Let us now consider a framework in which both Islamic and conventional firms co-exist in the same economy, but one where the Islamic firms are assumed to comply with Islamic values. For necessity goods, if all firms face a market price of P as shown in Figure 5, the Islamic firm will be able to obtain a positive economic profit (area PABC), while the conventional firm will only obtain a normal profit. In the long-run, the positive profits enjoyed by the Islamic firms will attract other firms (most likely the Islamic ones) to enter the industry, thus driving down the market price. In the final outcome, we will find that more Islamic firms will produce necessity goods. Conversely, for refinement goods, the opposite holds, that is, more conventional firms will end up producing these goods, since the Islamic firms will not find it profitable to enter the market (see Figure 6).

The outcome in Figures 5 and 6 can also be shown mathemati- cally as follows. Since for necessities, the total cost, average cost and marginal cost faced by the Islamic firm will be lower than that faced by the conventional firm, at each level of positive output therefore minAC s <minAC c , AC s and AC c are the average costs of the Islamic and conventional firms, respectively. If P is the price level that would give the conventional firm normal profit, then, minAC c =P. Since the

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Price AC C MC C S MC AC S P A MR=AR=D Profit C B
Price
AC C
MC C
S
MC
AC S
P
A
MR=AR=D
Profit
C
B
Quantity
*
*
q
q
C
S
Figure 5: Production of Necessity Goods of Islamic and Conventional Firms within the Same Competitive
Figure 5: Production of Necessity Goods of Islamic and Conventional
Firms within the Same Competitive Markets
Price
AC S
MC S
MC C
AC C
D E
Loss
P
F
MR=AR=D
Quantity
*
*
q S
q C

Figure 6: Production of Luxury Goods of Islamic and Conventional Firms within the Same Competitive Markets

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two firms coexist in the economy, and if P is the prevailing price in the market in which the Islamic firm is also a price-taker, then, minAC s <P, and the Islamic firm will obtain positive economic profit. On the other hand, for refinement goods, the total cost, average cost and marginal cost faced by the Islamic firm will be higher than that faced by the conventional firm, at each level of positive output therefore, minAC s >minAC c . Similarly, if both firms coexist in the same economy and if P is the prevailing price in the market in which the Islamic firm is also a price-taker, then, minAC s >P, and the Islamic firm will obtain a negative economic profit. From the above analyses, it can be seen that the profit- maximizing behaviour of firms under the Islamic framework ensures a better allocation of resources with respect to the hierarchy of needs of the society. Necessities will be produced at a much higher level compared to refinement goods, and this will give greater benefit to the society as a whole.

IV. Conclusion and Policy Implications

This paper demonstrates that profit maximization can still be applied in an Islamic framework to achieve the desired outcomes of an Islamic economy, provided that Islamic values are explicitly incorporated particularly in the measurement of the cost of production of an Islamic firm. In relation to this, taking ethical values into account in the valuation of opportunity costs as part of the total cost of production will help ensure the production of the ‘right’ goods and in the ‘right’ amount, thus promoting allocative efficiency in the market. This paper presents a simple theoretical model to support this proposition for both perfect and imperfect markets by comparing the outcomes under the Islamic and conventional frameworks. In addition, we have also examined the outcomes for the case of both conventional and Islamic firms co-existing in the same economy. The analysis has focused essentially on the production side of goods and services, assuming that the demand for such goods and services in an Islamic framework does not differ from the conventional framework. However, if consumers also behave according to the Islamic values, we expect that the production of necessity goods will rise in response to higher demand for these goods, and the production of refinement goods will be lower under the

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condition that the economy has yet to fulfil the basic needs of the society. The economic environment and the values that economic agents hold at present may not completely conform to the ideal Islamic values. Hence, there is a need for the authorities to undertake certain measures to achieve the outcomes that the model has presented. As mentioned earlier in the paper, one of the goals of an Islamic economy is to fulfil the basic needs of the society. If the market is left on its own, it may not be able to achieve this. Thus, the government should undertake the responsibility of ensuring that this goal is attained, since in an Islamic economic system the government should coexist with the market on a permanent and stable basis (Kahf, 1978: 48). Among others, the government can choose to impose taxes on the production of refinement goods or provide subsidies for the production of necessities so that the social costs or benefits associated with the type of good produced can be internalized within the cost structure of the firm. In addition, other incentives to produce necessity goods may take the form of providing physical infrastructure, training and consulting services to producers. Furthermore, research and development activities should put more emphasis on necessity goods. With respect to the production of refinement goods, another disincentive can be in the form of restriction of permits to produce such goods. In the long-run, such measures combined with a sustained effort to educate all economic agents and make them aware of the proper Islamic values, and of the importance of placing a high priority on fulfilling the needs of the society.

NOTES

1. Zak¥h is an obligatory financial levy on all surplus wealth and agricultural income of Muslims. It is charged at varying rates and the objective is to provide financial support to specified categories of people such as the poor and the needy (Khan, 1994).

2. Hallaq (1995) argues that spending on charity increases average cost for the Muslim firm, but the marginal cost remains the same as for the non-Muslim firm. This argument is erroneous since spending on charity is a function of profit, and therefore it must also depend on output. Hence, both the average and marginal costs should be different for the Muslim firm. In Bendjilali and Taher (1990), profit and output are treated as two independent variables, where one can change while keeping the other constant. This is clearly incorrect since profit is a function of output, and thus profit will change as output changes. In

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addition, they derive a general condition for a Muslim monopolist to produce more than the profit-maximizing level, which they then apply to the Cobb- Douglas class of utility functions. However, the condition derived is not the condition that permits production higher than the profit-maximizing level, rather the parametric restriction is for the second order condition of utility maximization. Metwally (1992) assumes that changes in expenditure on charity

δP

(G) will increase demand at given prices (P). However, this is stated as > 0. In

δG

addition, he defines profit as the difference between the firm’s revenue and its production and charity costs. However, he subsequently treats both production costs and charity costs as separate entities in the model. Furthermore, we found errors in the derivation of the first order condition for utility maximization, hence the conclusion he derives may not be valid.

3. It is recognized that the distinction between necessity, convenience and refinement good is somewhat nebulous with respect to individuals and epoch. However, for the purpose of analysis, this paper maintains the definitions given, for a particular point in time.

4. As mentioned earlier, it is implicitly assumed here that the economy has yet to fulfill the needs of the society. Therefore, higher amounts of necessity goods produced is assumed to give higher benefit to the society as compared to refinement goods.

5. In the analysis, the authors consider the best alternative to the production of a necessity good is the production of a refinement good. The two contrasting goods are deliberately chosen to provide a clear distinction between the two kinds of goods so that the difference in the ma|la^ah can be easily distinguished. However, it is not necessary to have such a restriction. The analysis and results will still hold as long as the next best alternative good has a position lower in the hierarchy of goods than the good in production.

6. A similar argument, as in preceding note (n. 5) applies to the production of a refinement good. In this case, the analysis and results will still hold as long as the next best alternative good has a position which is higher in the level of hierarchy of goods than the good in production.

7. The authors disagree with Mannan (1992) who refuted the ‘given demand hypothesis’. This is because the market demand curve is assumed to reflect effective demand upon which the firm should base its decision.

8. This is one possible outcome, where a firm’s profit-maximizing output level is the same under both the Islamic and conventional frameworks. It is also possible to obtain the profit-maximizing output, for an individual firm in the Islamic framework, at either a lower or higher level than the conventional outcome, depending on where the marginal cost (MC s ) intersects the price level (P s ). See the Appendix for the mathematical demonstration of this. However, in all of these cases, the final result will still hold, i.e., total output produced by the industry in the Islamic framework will still be higher and the price level lower than in the conventional framework in the long-run.

9. Again, the profit-maximizing output level of the firm in the Islamic framework may be lower, higher or the same, as is the case for necessities. Similarly, the final result will still hold, i.e., total output produced by the industry in the Islamic framework will be lower and the price level higher than in the conventional framework in the long-run. Again, see the Appendix for the mathematical demonstration.

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APPENDIX

Conventional firm:

For the conventional firm, the cost function is given by:

C=E(q)+I c (q),

where E(q) = explicit cost I c (q)= conventional implicit cost

The average cost of the firm will be:

AC =

E(q)

q

+

I (q)

C

q

The minimum point of the AC curve is obtained at:

AC ′ =

qE (q )

E(q)

q

2

+

qI

C

(q )

q

2

I (q)

C

= 0

*

Let the output level corresponding to this minimum AC be q c .

Islamic firm:

For the Islamic firm, the cost function is given by:

C

S

=

E(q)

+

I

C

(q )

+α

(q)

,

where E(q) = explicit cost I c (q)= conventional implicit cost α(q)= the Islamic valuation of opportunity cost of the good based on ma|la^ah.

α(0)=(0),

α´(0)<0 for q>0, for the production of a necessity good in which the best alternative is a refinement (luxury) good, and

α´(0)>0 for q>0, for the production of a luxury good in which the best alternative is a necessity good.

The average cost of the firm will be:

AC

S

=

AC

+

α(

q

)

q

The minimum point of the AC curve is obtained at:

AC

'

S

=

=

'

AC

AC

'

(

q

)

(

q

)

+

+

q

α

'(

q

)

α

(

q

)

α

'(

q

)

q

2

q

α

(

q

)

q

2

= 0

*

Let the output level corresponding to this minimum AC be q s .

For necessity goods, α(q)<0, α´(q)<0, for q>0. Therefore:

*

If qα´(q)=α(q), then q s =q c .

*

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*

If |qα´(q)|>|α(q)|, then q s >q c .

*

*

If , |qα´(q)|<|α(q)|, then q s <q c .

*

For refinement (luxury) goods, α(q)>0, α’(q)>0, for q>0. Therefore:

*

*

If qα´(q)=α(q), then q s =q c .

*

If |qα´(q)|>|α(q)|, then q s >q c .

*

*

If |qα´(q)|<|α(q)|, then q s <q c .

*

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