Contributions To Islamic Economic Theory

CONTRIBUTIONS TO ISLAMIC ECONOMIC THEORY
By the same author
AN ISLAMIC SOCIAL WELFARE FUNCTION

MANPOWER PLANNING AND POLICIES IN SAUDI ARABIA
CONTRIBUTIONS TO
ISLAMIC ECONOMIC
THEORY
A Study in Social Economics
Masudul Alam Choudhury

Associate Professor of Economics
University College of Cape Breton
Nova Scotia, Canada
Palgrave Macmillan
ISBN 978-1-349-07730-4 ISBN 978-1-349-07728-1 (eBook)
DOI 10.1007/978-1-349-07728-1
© Masudul Alam Choudhury 1986
Softcover reprint ofthe hardcover 1st edition 1986 978-0-333-38507-4
All rights reserved. For information, write:

Scholarly & Reference Division,
St. Martin's Press, Inc., 175 Fifth Avenue, New York, NY 10010
First published in the United States of America in 1986
ISBN 978-0312-16881-0
Library of Congress Cataloging-in-Publication Data

Choudhury, Masudul Alam, 1948-
Contributions to Islamic economic theory.
Bibliography: p.
Includes index.
I. Economics-Religious aspects-Islam. 2. Islam-
Economic aspects. I. Title.
BPI73.75.C48 1986 279'.19785 85-22149
ISBN 978-0-312-16881-0
To my loving wife, Nuzhat, and my dear children,
Mufeedh, Nafay and Moaz
Contents
List of Tables ix
List of Figures x
Acknowledgements xi
Preface xiii
List of Meanings of Arabic Transliterations XVI
Introduction: Towards a Definition of Islamic Economic

Theory
PART I PRINCIPLES 5
1 Principles of Islamic Economics 7
PART II MICROECONOMICS 21
2 An Islamic Approach to the Theory of Consumer Demand 23
3 First-order Efficiency Conditions of the Firm in an Islamic
Economy 33
4 Introduction to the Financial Statement of the Firm in an
Islamic Economy 40
5 The Role of zakah, the Islamic Quasi Wealth Tax, in
Resource Allocation 51
6 An Analytical Model of Profit-sharing in an Islamic
Economy 72
7 Microeconomic Decision-making in an Islamic Framework 87
8 Formation of Social Ordering in an Islamic Welfare
Economy 108
vii
viii Contents
PART III MACROECONOMICS 121

9 Investment Theory in an Islamic Perspective 123
10 Macro Consumption Function in an Islamic Framework 140
II Macroeconomic Relations in the Islamic Economic Order 166
PART IV POSTSCRIPT 189

12 Towards a Methodological Development of Islamic
Economic Theory 191
Notes and References 217
Subject Index 237
List of Tables
5.1 Estimates of Per Capita Income and zakah for Saudi
Arabia at Market Prices, 1960-75 67
5.2 Linear Distribution of Per Capita Income and zakah for
Saudi Arabia, 1970-75 68
5.3 Estimate of the Coefficient 'A' in the Income-zakah
Relation for Saudi Arabia, 1970-3 69
10.1 Effects of Introduction of zakah as a Tax on Short-run
Savings at Different Levels of Marginal Propensity to
Consume 159
10.2 Values of MPS· for Different Values of Pwhen Zl = 0 161
10.3 Values of MPS· for Different Values of Pwhen z = 0.025 162
ix
List of Figures
2.1 Price-Quantity Relationship in an Islamic Framework,
and Indifference Curves Comparison with the Con-
ventional Consumer Behaviour 30
3.1 Pricing Mechanism of the Firm in an Islamic Economy 38
4.1 Implications of the Optimal Dividend-Retained Earning
Trade-off 49
5.1 Relationship Among zakah Rate, Investment and Income
in the I-Economy 64
6.1 Income-Employment -zakah Relationship 75
6.2 Adjustment Process between Profit-sharing Ratios with
Varying Profit rates 80
6.3 Substitution and Income Effects in Optimal Investment
Decision in a Diversified Portfolio 83
7.1 The zakah -Benefit Multiplier Relation and Conformable
Utility Frontier 103
7.2 p-I-K Relationship in an Islamic Economy 106
9.1 Optimal Allocation ofInvestment in an Islamic Economy
Intertemporally 134
ILl Demand, Supply Shifts and the Profit-Liquidity Trap in
the Islamic Monetary Sector 175
11.2 Macroeconomic General Equilibrium System of the
Islamic Economy 184
12.1 Ethico-economic Equilibrium in the Consumption and
Production Sets 213
x
Acknowledgement
I express my gratitude to the Rockefeller Foundation in New York for
its award of scholarly residency to me at its prestigeous Bellagio Study
and Conference Centre in Italy, to complete this book. This unique
opportunity enabled me to accomplish the work quickly.
I also express my thanks to Professor Fahim Khan of the
International Centre for Research in Islamic Economics, King
Abdulaziz University, Jeddah, for allowing me to include one of his
valuable contributions in my book. I also express my thanks to those
publishers who have given me permission to reproduce my earlier
contributions in this book. Each of them has been duly acknowledged in
the appropriate notes.
MASUDUL ALAM CHOUDHURY
XI
Preface
This book is intended to fulfil the requirement for a systematic
presentation of Islamic economics as a special case of social economics,
and extending thus, the methodologies of mainstream economics. The
book thereby contains a list of chapters and topics in each of the sections
on Principles, Microeconomics, Macroeconomics and a Postscript,
which in an integrated way, convey the theory of Islamic economics
within the well-known framework of mainstream economics. The
methodology used in each of the chapters is rigorously analytical,
combining a discussive, geometric and mathematical approach, and
extending it to the analysis of factors that may be of a purely economic
nature or of a socioeconomic nature. Thus, a blending between the
mainstream and social approaches to economic analysis. The book is
also a work in normative economics, as it develops and systematically
presents the theory of Islamic economics based on its fundamental
sources, the Quran (Holy Book of Muslims), Sunnah (Traditions of
Prophet Muhammad) and ijtehad (authoritative Islamic research).
Social economics and mainstream economics are today competing
views of a new wave of thOUght on the economics of the future. The need
for re-examining the age-long postulates, approaches and objectives of
conventional economics is pressing today because of the adverse cyclical
problems of recession and the fears of uncertainty in attaining sustained
growth over the long run. Equally, the inequitable distribution of
economic opportunities within a given society as well as among the
nations of the world, caused by the existing economic institutions, has
seriously put to question the very foundations of conventional econ-
omics, namely, the philosophy ofthe welfare state and the good society.
The patchwork policing of the mainstream economists following the
Keynesian tradition of short run analysis is failing in popUlarity among
many today. In the unsettled milieu of controversies the social
economists have stepped in to propound a new theory of economics. It
would rely on factors that are both of a purely economic as well as of a
non-economic nature, such as philosophy, religion and value judge-
ments. The result would be to formulate a political economy of social
xiii
xiv Preface
policy, which the social economists think would be more conducive for
the advance of mankind towards the Good Society.
Islamic economics can be considered as a special case of social
economics. It represents an approach to economic analysis that is strictly
steeped on the premiss of shariah or Islamic law as it pertains to social,
economic and legal matters confronting the Islamic society. The theory
of Islamic economics is the logical explanation of the workings of the
Islamic religious elements in economic matters. While this theory
emanates basically from the fundamental religious sources of the
Islamic faith, that is, Quran, Sunnah and ijtehad, the principles,
assumptions, functions and goals of the Islamic economic order are
universal in nature. They are thus amenable for a thorough scientific
investigation. This book purports to bring this out in the following
pages.
It is therefore hoped that this book will meet the need of a textbook
for students and academics undertaking a serious study of Islamic
economics, social economics, history of economic thought and com-
parative economic systems. The book would serve as a reference
material in these areas of economics. It will also be of interest to
professionals in international development institutions, national
government offices, corporations and businessmen, who are quite often
involved in dealing with their counterparts in the Arab Gulf countries.
To them this book will introduce the economic philosophy of some
major institutions in the Arab Gulf region, such as the Islamic banks,
Dar al-Mal-al-Islami (Geneva), the Islamic Development Bank,
Kuwait Finance House, joint ventures and profit-sharing projects in
Saudi Arabia and so on.
Part I of the book deals with principles. It delineates the general
nature of the Islamic social sciences. It then builds upon this the
definition, principles and methodological approach of the theory of
Islamic economics.
Part II further builds upon the principles of Islamic economics in the
area of mainstream microeconomics. Thus, we have a chapter on:
consumer demand, pricing theory of the firm, financial theory of the
firm, resource allocation, principles of economic decision-making at the
levels of the firm, the organisation and the state, valuation of the firm
and a formulation of Islamic welfare economics.
Part III constitutes the logical extension of Part II in the area of
mainstream macroeconomics. We have integrated this section by a
chapter on: the Islamic investment theory, the Islamic consumption
theory, and the general equilibrium macroeconomic system.
Preface xv
Part IV constitutes the Postscript on a methodological development

of Islamic economics as a rational economic theory. This section brings
together the foundations of microeconomic theory and macroeconomic
theory to establish the existence of a general equilibrium in the ethico-
economic field. This ethico-economic field is made up of a consumption
set, a production set, and both being determined by a well-defined
ethical set in the first place. The social welfare theory then follows as a
result of the analysis in the ethico-economic equilibrium field.
The four parts of the book are integrated together to present a
coherent and logical development of the main topics of Islamic
economic theory. However, while the area of Islamic economics still
denotes a humble beginning, particularly as a study in economic
analysis, any work in this area at this stage is subject to an immense
possibility of improvement and development. This is indeed true of any
book in the ever-moving realm of economic analysis. The singular
contribution of this book could be that it presents, for the first time, a
systematic and self-contained work on the theory of Islamic economics
as a special branch of social economics, acquired within the general
methodology of mainstream economics.
List of Meanings
of Arabic Transliteration
ARABIC TRANSLITERATIONS MEANING
akhira knowledge of the Divine Judgement to
follow after life
al-Hisbah an Islamic institution that promotes
common goodliness among individuals in
an Islamic society
al-Afw Quranic injunction to spend out of what is
left over after meeting ones needs
Bait ai-Mal public treasury in an Islamic state
Dar -al-Mal-al-Islami an Islamic finance company based in
Geneva, Switzerland
fai property acquired in war without fighting
fidth part of fai whose mode of distribution in
society is similar to zakah (see below)
fiqh Islamic legal study based on original
sources
ghanimah war booty
hadith (plural:
ahadith) sayings of the Prophet Muhammad
halal Islamically permissible
haram Islamically forbidden
ibadah Islamic worship of God
ihsan Islamic ethical perfection
ijma acceptance of the findings of ijtehad by the
Muslim community at large
ijtehad authoritative Islamic research
islah righteousness and benefits to human
societies
israf wasteful consumption
kharaj tax on land conquered during war
khilafah man's vicegerency in the universe
xvi
List of Meanings of Arabic Transliteration XVll
la israf not to consume in waste

mafasid total cost
maqasid al-
shariah the basis of an integrative and systematic
approach to Islamic values
masalih total benefit
mua'malat affairs of the world
mudarabah Islamic principle of profit-sharing in busi-
ness enterprise
muhtasib man in charge of running the al-Hisbah
institution
musharakah (also
masharakah) Islamic profit- and risk-sharing principle in
joint ventures
nisab (an-nisab) a minimum exemption level for the levy of
zakah (see below)
qard-i-Hasan loan without interest
Quran holy book of the Muslims
riba interest on capital (surplus value)
risalah Islamic concept of prophethood
rububiyyah sole proprietorship of the means of
production
sadaqah Islamic voluntary charity
salah (also salat) Islamic prayer
shariah Islamic law
shirakah see musharakah
shura Islamic consultation
sunnah traditions and instructions of the Prophet
Muhammad
taqwa Godfearingness
tawheed unity of God
ulema doctors of Islamic law
ushr Zakah on crops (see below)
waqf property endowment for usage in Islamic
causes
zakah (zakat) a capital and wealth tax levied on individ-
ual Muslims having savings and assets
valued above the nisab level of exemption
Introduction: Towards a
Definition of Islamic
Economic Theory*
The question whether the idea ofIslamic economics is meaningful, well-
defined or practical has been occupying the minds of many people for
some time. There are those among Muslims who wonder whether such a
discipline is at all applicable in today's complex world of economics and
international relations. There are others who have just started to grapple
with the problems of its definition and structure. 1
In the West the sudden outburst of the political economy of Middle
East oil, the Islamic revolution in Iran and the growing self-assertion of
a Third World economic order led by oil-rich Muslim states have
brought the subject of Islamic economics to the attention of some
scholars. 2 The basic question being raised is, what does it really mean?
Therefore the problem to which an Islamic economist must address
himself is the definition of Islamic economics and, broadly, of Islamic
economic theory.
The economics of Islam as it stands today is just a digit in a vast
number of potentials. It has not advanced with the tempo and vigour of
modem economics. What the Muslim economist has today in this field
are just the rudiments of certain principles of Islamic behaviour and
public policy derived from the works of the glorious past. Notably
among these are Ibn Khaldun,3 Ibn Taimiyya,4 Imam Ghazzali 5 and
others between the sixteenth and eighteenth centuries; and in con-
temporary times Maududi,6 Sadr,7 Abduh,8 Waliullah,9 ShatibpO and
a number of others. In addition we have of course the principal sources
of Islamic knowledge, the Quran and the traditions of Prophet
Muhammad. 11 Yet the disciplines termed economic theory or economic
* This Introduction is abstracted from the author's paper that appeared in the
Contemporary Review. vol. 239, no. 1387 (Aug. 1981).
2 Introduction
analysis are of recent origin. They owe their development in the

eighteenth century to the emergence of the political economy of market
mechanism, propounded first by the laissez faire principles of Adam
Smith, refined later by the methodological rigour of the Ricardian
system ofthe value and determination of the profit rate in agriculture as
a primary regulator of economic growth. 12
This development was followed in the early nineteenth century by the
pleasure and pain calculus of utilitarianism, whose chief exponent was
Bentham. The idea of utilitarianism was instantly taken over by the
neo-classical school, led by Alfred Marshall in England, Menger in
Austria and Walras in Switzerland, and the neo-classicists bequeathed to
the world the idea of marginal utility, thereby explaining the demand
side of price formation. The economic story-telling did not end there. It
got newer twists in the socioeconomic analysis of historical change by
Marx and the rebirth of macroeconomics with Keynes's General Theory.
Over the years since the eighteenth century the objectives of modem
economics have changed significantly. One can associate three major
foci of development. In the first half of the nineteenth century economic
analysis was concerned with the problems of distribution. After 1870 it
became concerned with the problems of optimal allocation of resources
among competing ends. Finally, since the rebirth of macroeconomic
theory, it is concerned with the problems of economic policy relating to
employment, the generation of aggregate demand for goods and services
and price stabilisation.
This is admittedly a somewhat sweeping account of the growth of
economic theory as it stands today. But has economic analysis or, in
Schumpeter's words, 'economic science', really progressed? Certainly it
has done so in methodological content. The configuration of economic
analysis has been unsparingly mathematised. Recently a long chain of
eminent economists became preoccupied in analysing the structure of a
general equilibrium for the economic field. 13 Samuelson is, of course, a
champion of this cause. In his Foundations of Economic Analysis he
showed that the general equilibrium framework of economics has much
in common with that of a physical system.
Western economists since time immemorial have concerned themsel-
ves only with the view of man as homo economicus. This was sufficient for
erecting their structure of market mechanism. Everything else that was
beyond empirical analysis was excluded. Schumpeter's well-known
work on the history of economic analysis discerned a complete removal
of matters of ethics and values in the economic system on grounds that
were empirical. 14
Introduction 3
Schumpeterian caveats apart, the fact remains that economic science

is certainly not devoid of value judgements by economists, or of the
ideological, social, moral and political backgrounds of different people
from which the value judgement springs.
But to return to an understanding of the principles of Islamic
economics - Islam is a coherent religion of both worlds, the present and
the hereafter. Every reward in the next world is an inverse definable
function of human action in the present world. IS The significance of the
latter is indicated by the impact it leaves on specific functions of an
Islamic society. In the words of Naqvi, 16 'Islam is a self-sufficient entity,
with clearly defined features - an arabesque wherein reside the religious,
economic and social dimensions, providently equilibrated to form a
unity.' The guiding laws ofIslam that relate to all different dimensions of
human life are known as shariah. Of course, there are the two branches
of the Islamic Divine Law, namely, ibadah, meaning Islamic worship,
and mua'malat, meaning 'affairs of the world.' In the eyes of shariah
they are one and the same. 1 7 This is basically the fundamental difference
in the approach and content of the Islamic social sciences from those of
others. There is a claim in certain quarters that similar views were
vouchsafed by the scholars of the Enlightenment. This is untrue.
Let us first consider St Thomas Aquinas's ideas on economic analysis.
He is known to have made a clear distinction between secular and sacred
matters as they comprise the social sciences. Thus he excluded whatever
was the sacred doctrine from an analysis of the market system, and
'assigned no other prerogative to the sacred law but that of a super-
mundane dignity and did not give it any authority over the latter'.ls
Thomas Aquinas's era was followed by the age of natural law
philosophy, and subsequently by the age of moral philosophy, a product
of the Enlightenment. Moral philosophy was literally defined as the sum
total of the sciences of the 'mind' and 'society'. Alas it fell into the hands
of specialists in individual branches of moral philosophy, who neglected
the need for co-ordinating the different branches based on comprehens-
ive principles, and this was particularly true with economics.
The collateral existence of a purely worldly action side by side with
Islamic ethical attitude is indeed a means of convenience in an Islamic
society. For example, the voluntary payment of zakah, an annual wealth
tax for income-redistributive purposes levied by an Islamic state on the
well-to-do, is primarily an act of Islamic belief, but the economic
rewards of this payment are many. Zakah can be spent on training the
needy, thus reducing structural forms of unemployment,19 increasing
earnings, productivity and social welfare. Again, there is the example of
4 Introduction
fa israf, meaning the Islamic religious constraints on Muslims against

wanton consumption. Individual action to act in this way is a matter of
pure belief. The economic benefits of fa israf are higher investment in
capital goods, and stabilisation of prices. 20
A definition of the Islamic economic theory is now possible and may
be defined as the sum total of the historical, empirical and theoretical
studies that analyse the human and societal needs in the light of an
integrated Islamic value system. The two elements of this are, first, the
purely marketable goods and services along with their prices and,
second, the augmentation of the benefits derived from the consumption
of these goods and services.
A priority area of Islamic economic theory would seem to be Islamic
welfare economics. In the light of this one would have to develop
carefully the criteria for ranking consumption and investment alternat-
ives, both from individual and social points of view,21 based on the
principles of the Islamic integrated value system as they apply. As
mentioned earlier, the criteria of choice of alternatives must be related to
the two types of benefits, the pure economic benefit, and the 'worldly'
equivalents of factors of pure Islamic belief associated with Islamic
consumption and investment behaviour, that finally augment the pure
economic benefit. This would require the development of a consistent
and quantitative Islamic economic general equilibrium system, endowed
with a mathematical form of the social welfare function. The function
must then be specified, empirically estimated and made capable of policy
analysis in an Islamic state. This to my knowledge is fundamental within
a general equilibrium analysis, for all the economic agents along with
their behaviour among each other are but elements of this grand system.
Part I
Principles
Part I of the book, on Principles, consists of one chapter that surveys the basic
philosophy of Islamic economics. It then collects the essential points together in
order to formulate the foundations ofIslamic economic theory. The structure of
Islamic economics is carefully specified in terms of the basic set of assumptions,
principles, economic institutions and policy instruments. These specifications
are important for the reader to understand fully at this point, as they are
constantly referred to in the subsequent chapters of this book.
1 Principles of Islamic
Economics*
The objective of economic analysis has changed significantly since the
nineteenth century. One can associate three major foci of development
in it. 1 In the first half of the nineteenth century economic analysis was
concerned with the problem of distribution. After 1870 it became
concerned with the problem of optimal allocation of resources among
competing ends. Finally, since the rebirth of macroeconomic theory in
the hands of Keynes, economic science has concerned itself with the
problems of economic policy relating to employment, the generation of
aggregate demand for goods and services and price stabilisation. In
short, modern economics has been preoccupied by the idea of one goal -
the satisfaction of the economic man, Marshall's homo economicus,
based on total, free and perfect competition.
Against this advanced and rather impressive fa~de of modern
economics we have a new economic order in the making. The central
issue of this economic order is efficient allocation of resources in the light
of a more transcendental consideration - that of a righteous community
promoting the laws of God on earth. This brings us to the central issue of
the new system of economic thought commonly being termed 'Islamic
economics' .
The main objective of this chapter is to delineate in non-technical
language the principles of Islamic economics in as far as they constitute
the philosophical basis of this economic system. We shall then look at
some of the key economic instruments that translate the Islamic
economic principles into action. The chapter will be of an introductory
nature in these areas and no elaborate economic analysis of the issues is
undertaken for the benefit of the common reader.
* This chapter is reprinted from Middle Eastern Studies, vol. 19, no. 1 (Jan. 1983).
7
8 Principles
PRINCIPLES OF ISLAMIC ECONOMICS
The Principle of Tawheed and Brotherhood
Islamic economics is not content with the conventional viewpoint of

economic analysis. It is motivated by its first cardinal principal - the
principle of tawheed and Brotherhood. Tawheedliterally means 'unit'. In
the economic context it summarises the crux of the entire essence of
Islamic economics in that it teaches man how to relate and deal with
other men in the light of his relationship with God. It says that behind
the workings of an economy based on market exchange, the allocation
of resources, the maximisation of utility and profits, is a more
fundamental truth - that of social justice. In Islam the capacity to
understand and dispense this social justice emanates from the knowl-
edge and practice of the principles of the Quran. In this way the principle
of tawheed and Brotherhood links up our duties to men with our duties
to God. In more practical terms the essence of tawheed and Brotherhood
lies in equality and co-operation. The Quran verily says, '0 mankind! be
mindful of your duties to your Lord who created you from a single soul
and from it created its mate and from them twain has spread abroad a
multitude of men and women. '2
An immediate corollary of the principle of tawheed and Brotherhood
is the predominant note oflslamic economics, that to God alone belongs
whatever is in the heavens and in the earth, and that He has made the
good things for the service of man. 3 Man has been created as the
vicegerent of God on earth entrusted with the just use and distribution of
His resources. 4
The Principle of Work and Productivity
The second basic principle of Islamic economics is that of work and

compensation for work performed. It states that an individual's wages
must be proportionate to the amount and category oflabour performed
by him. The amount oflabour would be measured in, say, man-hours of
work and the category of labour would be specific to different
professions. The wages in the latter case would be constrained by the
minimum of the rent determined for the category of labour in demand.
Whenever an individual acquires income greater than what is due to
him by dint of his input of labour and other resources, which produce
this income, he commits what is known as rubuhiyyah, that is, sole
Principles of Islamic Economics 9
proprietorship of the means of production. Because Islamic economic

ideas hold that fundamentally all means of production belong to God,
so an individual by transgressing this limit commits a form of excess.
Under this category of excess are included rent on land and share-
cropping, but rent on real capital is permitted. S As regards the
prohibition of the rent on plain land we have the hadith (saying) of
Prophet Muhammad, that 'He who has a land should cultivate it and
should not rent it - not even for a third or fourth of its crop and not for a
specific amount of food'. 6 Inherent in this hadith is the problem of value.
Uncultivated land has not received the labour of the owner and is
therefore not liable to a price until it is exploited to produce. Thus in the
first case we have the idea of value in use and in the second case the idea
of value in exchange.
It must be noted that rent was prohibited only on plain land, and not
on land in which there has been input oflabour and capital by the owner.
In the latter case it would be an act of injustice towards the landowner to
have him forgo for nothing in return the exchange value created in the
land by his labour and capital inputs. However, it is suggested strongly
that this rent cannot be in crops, but in money terms. In this regard we
have the following tradition mentioned by Abu Dawud, who quoted
Sa'd Ibn Waqqas, a companion of Prophet Muhammad, as saying. 'We
used to rent land and pay the owner as rent the produce on the banks of
the irrigation canals. The Prophet prohibited this and ordered us to pay
rent in gold and silver.'7 Thus, while rent was prohibited on plain land, it
was allowed in cultivated and used land. Share-cropping was prohibited.
The Principle of Distributional Equity
The third major principle of Islamic economics is the right of society to

redistribute private property. This is amply supported in several
Quranic verses. 8 The chief items of national income and transfer
payments used for redistributive purposes in an Islamic economy are
zakah (tax on wealth exceeding a certain exemption level called nisab),
sadaqah (voluntary charity), ghanimah (war booty), fai (property
acquired in war without fighting),fidth (a part offai whose distribution
pattern is similar to zakah), kharaj (tax on lands conquered during war),
'ushr (zakah on crops).
There is no order in the Quran that the various sources of funds must
be spent in strict accordance with the practice during the early period of
Islam. It is just the broad principles ofexpenditure of these funds as laid
10 Principles
down in the Quran and further elaborated through the Islamic legal
sources, such as the hadith (traditions of Prophet Muhammad), jiqh
(legal study based on original sources) and shariah (Islamic law as it
pertains to different affairs of life) that must remain sacrosanct. For
example, the way the four-fifths of ghanimah was distributed among the
Muslim soldiers in the early period of Islam was only an exigency at a
time when wars were thurst on the Muslims before an Islamic state could
be established. In these conditions there existed no standing army nor a
state treasury to finance a standing army. Therefore, the Muslim soldiers
during that early formative period were allowed their share of the war
acquisitions. However, in a modern Islamic state the army could be
regularly paid as are civil servants and war acquisitions would be added
to the state treasury.
Similarly the remaining one-fifth of ghanimah can go to the state
treasury to supplement organised forms of social assistance program-
mes. The part due to the Prophet and his near kin during the early
period of Islam can now be returned to the government for public
works.
Similar is the case with zakah expenditure in the form of an organised
social assistance programme undertaken by the state. The stated
categories of expenditure of the zakah fund can be extended to cover
programmes of employment creation, family welfare, rehabilitation of
the aged, unemployment insurance, income support during times of
economic losses and others. Even the rate of zakah, originally fixed at 2.5
per cent on all forms of assessed wealth exceeding nisab level at any given
point of time can be varied but only marginally.9
At the more micro level the Islamic law of inheritance helps to
redistribute private property. The Quran is clear on this point. 10 The
primary motive of the law of inheritance is to put a final check on the
concentration of material assets in the hands of a few.
In short, therefore, equitable redistribution of income and wealth is
incumbent upon the Islamic state and the individual, and has to take
place fundamentally on the basis of tawheed and Brotherhood. The
objective of this redistribution is to increase the productive transform-
ation of national income and wealth to the employment and welfare of
the citizens. Thus, when the early Muslim refugees, evicted from Mecca,
found refuge in the city of Medina, they became members of that society
and were treated on equal terms and not confined to camps and
charities. If a refugee could cultivate land he was given land to do so; if
he had traits of a trader he was allowed to open a business; whoever
could not manage had the help of a brother in faith.
ANALYTIC IMPLICATIONS OF THE ISLAMIC ECONOMIC

PRINCIPLES
The viability of the three major principles ofIslamic economics must be

tested on two grounds in order to establish the workability of an Islamic
economic system. First, they must be capable of rational economic
analysis. This rational economic analysis may not be of modern
economics but must be consistent with economic assumptions and
behaviour, normative or positive, at the micro and macro levels. Then
they must also be capable of translating themselves into practical
applications with the help of suitable Islamic policy instruments. Let us
first investigate the viability of the principles of Islamic economics in
terms of rational economic analysis.
Analytic Implications of Principle of Tawheed and Brotherhood
In order to establish the principle of tawheed and Brotherhood, Islam

makes the elimination of riba, that is, interest, and the redistribution of
individual and national wealth imperative. The Islamic state has
established institutions to bring these policies into effect. These are
discussed in the next section.
According to the neo-classical economic theory the distributive
components of the total annual gross product of the nation are used in
three ways: one goes to acquire more real capital inputs for further
production; the other goes to wages; the third is taken by the
entrepreneur in the form of profits, interest and rents, forming in this
way the capitalist's surplus value. The presence of interest rate and an
initial outlay of capital then gives rise to a continuous accumulation of
capital. In fact, the capitalist earmarks his income for this accumulation.
As capital accumulates, the rate of profit either falls or becomes
constant. The rate of interest rises and consequently investment falls. In
order to maintain the levels of his profits the capitalist lowers real wages
or causes unemployment.
Therefore, to facilitate the accumulation of capital in the hands of a
few at the expense oflowering wages and ofunempoyment, exploitation
of the labour force sets in. The principle of equality and co-operation is
therefore disturbed by the presence of interest in the accumulation of
capital.
Riba in Islam does not mean interest on loan capital only. Any raising
of individual or state claim of ownership beyond what Islam considers
12 Principles
lawful is therefore, to be considered as a limit to the ownership of the

means of production. This is, however, not tantamount to a socialist
economic doctrine on the exploitative nature of interest. The abolition
of interest in Islam is considered important so as to provide a check on
the exercise of the right of private proprietorship, and thereby to end the
oppression and exploitation of the labour force, while a free enterprise
co-operative system is maintained.
Analytic Implications of the Principle of Work and Productivity
In the framework of a pure exchange economy it can be shown that the

marginal conditions for the existence of Pareto optimality (the first-
order conditions of efficiency in a perfectly competitive market in
modern economic analysis) in the Islamic exchange system depends not
only on the ratio of the marginal utilities of product and wages for the
two individuals, but also on the ratio of the marginal utilities of the two
individuals, owner and labour, with respect to the level of product and
wages. The significance of this result lies in the fact that under the
principle of equality and co-operation and the institutions which
translate this principle into practice, marginal utility of the owner
depends not only on his returns from rents, but also on the wages which
he has to give to the labourer equitably. Likewise the marginal utility of
the labourer depends not only on the amount of wages he receives, but
also on the amount of rents, which he must justly give to the employer.
Clearly with respect to the ordinary exchange situation, the presence of
product and wage variables in the utility functions of the two individuals
introduces a distortion in the ordinarily known economic system.
Therefore, with respect to the ordinary solution for the first-order
conditions of Pareto optimality the Islamic solution to the exchange
problem given above leads to what is known as a second-best solution,
but only with regards to the ordinarily known concept.
A second-best solution is an economic expression denoting a state of
resource allocation that is not efficient, but where efficiency can be
improved by certain external actions. Such corrective actions can be
wielded by the government, through taxes, subsidies and government
expenditures, by a powerful politically conscious populace, through
their demands for certain value systems, and other non-market forces.
In an Islamic economy, as aforementioned, it is the essence of co-
operation between labour and employer in a productive work environ-
ment that constitutes the corrective force of a second-best situation. An
Principles o/Islamic Economics 13
economic second-best solution is indeed a more realistic state of the

market economy.
Once the allocational principle with regard to land rent and profit-
sharing has been established, Islam then allows profits on the produce of
the land. Therefore, the value of the product sold in the market is
determined by wages, rents and profits. Mark here the Smithian concept
of the 'natural price' of a commodity.
The essence of co-operation referred to above while discussing the
labour-employer relation in the work environment, is more extensive
than only this in the Islamic economy. It tends to replace the idea of
competition in a modem market economy. The principle of co-
operation involved here is that when certain firms in the Islamic
economy find themselves at odds in competing with other firms they are
encouraged to enter into partnership with owners of more viable
enterprises. Such partnerships then entitle the owners and partners to set
their mutually agreed upon profit-sharing rates. Such a system of profit-
sharing in fact pervades both the private and the public sectors in an
Islamic economy, and is referred to in the Islamic literature as
mudarabah.
In a modem market economy, technically, whenever such partner-
ships occur some degree of efficiency in resource allocation is considered
to be lost, for instance, in the case of mergers and oligopolistic
competition. The perfectly competitive conditions of the modem
market economy then fail to exist.
This elementary idea of the difference in the principles of co-operation
in an Islamic economy versus the principle of competition in a modem
market economy is an important one. This difference brings about
further differences in the functioning of the institutions in the two
systems and on the concept of economic efficiency as ordinarily
understood.
Analytical Implications of the Principle of Distributional Equity
The analytical relations developed by the author elsewhere 11 on the

relationship of zakah to per capita income and zakah to labour force
activity can be succintly summarised here to show the role of zakah in
economic activity. Zakah is found to be associated with an income
multiplier effect. This can be explained via the relationships between
zakah rate and earnings through changes in the investment level. Since
zakah is imposed on idle assets only, which can be put to productive use,
14 Principles
so economic rationality will call for a depletion of all idle stocks to make
room for investment flows. Increased investment will thereby cause
increasing income through the multiplier effect, calculated at the end of
the zakah fiscal year. Therefore if the zakah rate increases it will cause
holders of idle capital to put them into productive use. Investment flow
will cause income to rise through the multiplier effect. Hence the
mUltiplier is a positive function of the zakah rate. Since the zakah rate
and the income multiplier are positively related, therefore, an increase in
the zakah rate brings about increased income through increased
investment flow, which in tum creates higher labour-force participation
rate.
The principle of distributional equity implies that there is serious
responsibility on the state efficiently to distribute national output
among the people and institutions. This further implies that there is
allowance for a good degree of government intervention in the Islamic
economy. Unregulated freedom of enterprise and the earning of
exorbitant profits may at times prove reprehensible to society. Some
may earn inordinate wealth out of profits and the availability of labour
and capital in production, while others would not be able to have such
easy access to the factors. But on the other hand God has allowed equal
right of usage of these factors to all. In such circumstances the strictly
public common pool like the Bait ai-Mal (public treasury in an Islamic
state) serves to control and distribute wealth and national output
according to the principle given above. Therefore, besides the obligatory
tax - that is, zakah - the individual has also to spend in the path of God
for the propagation oftruth. Finally, ifhe still has private property, this
cannot be concentrated on a single hand after his death. Children and
near relatives, or failing these, distant relatives, whether male or female,
are lawful heirs and their shares are given by fixed percentages as stated
in the Quran. Islam also recommends him to make a will for welfare
projects, which normally shall not exceed one-third of his property.
POLICY BASIS OF THE ISLAMIC ECONOMIC PRINCIPLES
Let us now address ourselves to the second test of viability of the three
fundamental principles of Islamic economics, namely, how they can be
translated into practical application. The three major principles of
Islamic economics are put into effect by four key instruments of policy
on which other policy instruments can be built. They are (l) the
abolition of riba, meaning interest on capital; (2) the institution of
mudarabah, meaning profit-loss-sharing system in Islamic economic
ventures; (3) the abolition of israf, meaning wasteful consumption, and

(4) the institution of zakah, which is an organised form of social
assistance in an Islamic society financed by tax on all forms of income
and wealth exceeding a certain minimum exemption level called nisab.
Abolition of riba
Islam categorically disapproves of the existence of interest in all

economic transactions. The Quranic concept of riba is not limited to
loan interest. Literally, riba means over and above a thing, be it in money
terms or in physical units of goods. When money is involved in
exchange, riba refers to the form of excess that was taken by the pre-
Islamic Arabs over and above the principal loaned out for a period of
time. When commodities are exchanged by weight or measure, then
there must be strict equality in such weight and measure, and immediate
delivery of both goods. However, if the commodities are of different
species, then equality is not insisted upon but delivery must be
immediate. 12
Modem exchange economy justifies the need for interest in order to
achieve allocative efficiency as interest is assumed to cover the cost of
capital in production. By thus maintaining the recovery of capital
depreciation in production an initial outlay of capital becomes a source
of a continuously increasing stock of capital in future periods of time,
and this promotes the production process. This idea would indeed be
acceptable in Islamic economics of riba if interest was in fact truly
related to the actual proceeds from production, for in that case the rate
of interest would be the same as the rate of growth of output. But in
reality, the rate of interest being a pre-fixed percentage on capital,
measuring speculative and not actual cost of capital, is an exogenous
variable. It is determined outside the production system.
In the Islamic economy only the actual cost as determined by
production cost can be taken into account in compensating capital
depreciation, and not the speculative cost component. Therefore, the
rate of interest is replaced by the rate of profit, which in tum is
determined by contractual percentage shares in an Islamic profit-Ioss-
sharing mechanism known as mudarabah -musharakah.
Institution of mudarabah
In the absence of interest in economic transactions Islamic banks would

not function as modem banks do. That is, unlike the modem banking
16 Principles
system the Islamic banks would not be in a position to create unlimited

liquidity based merely on the notion of expected demand by creditors.
This has its logical explanation - if expectational demand for liquidity is
not satisfied when it becomes due, there will be recessionary pressures in
the economy. The economy remains below potential rate of growth,
under-utilisation of production capacity puts upward pressure on the
cost of production. Consequently, market prices for goods and services
rise. On the other hand, if the supply of money exceeds the demand for
money, there will be inflationary pressures on the economy, -for now
there is too much money around, but producers decide to cut back on
production capacity and investments are subsequently not forthcoming.
Incomes rise, but not due to the force of labour productivity or
technological change, but due to the supply effect of money on prices
and incomes.
In the search for monetary policies to control such recessionary or
inflationary situations banks either move to an easy money supply
policy or to a tight money-supply policy, respectively. The interest rate
goes down and then gets pegged in the case of easy money supply, and
moves up and then gets pegged in the case of tight money supply. 13 The
interest rates thereby continuously swing between the two ends over
long periods oftime in the hope of creating the balance between ex-ante
demand and ~x-post supply of money.
If there was no interest the purchasing power of money would be used
up either in consumption or in investment, directly through banks
operating on the principle of profit- and risk-sharing in ajoint enterprise
in an Islamic economy. This is the institution of mudarabah in Islamic
economics. In the presence of mudarabah the rate of interest is replaced
by a positive rate of profit. 14 A positive rate of profit arrests the problem
of speculative demand for cash balances, because the ex-ante demand
for money capital is reduced to an actual demand and this is based on a
pure contractual sharing of profits from a joint venture in accordance
with relative costs or relative capital outlays in a given production or
investment.
The institution of mudarabah when applied to public-private sector
joint ventures is a powerful medium of risk diversification. Public
enterprises are found to be only marginally risk-averse in their
investment behaviour, particularly because they can easily diversify the
total risk capital in the public enterprise by distributing it over a large
number of investment projects. 1 5 Risk neutrality on the part of the
public authority encourages real investment in the economy. Increased
allocation of money capital into real investment reduces the amount
available for consumption expenditure, but only to a certain desired

level, so as to maintain an optimal allocation of capital between
consumption and investment intact.
Excessive consumption is emphatically discouraged by Islam and the
means to do it is the institution of mudarabah, that automatically brings
about a desired allocation of money capital between consumption and
investment activity while encouraging investment in real capital.
Abolition of lsraf
Excessive or wasteful consumption, be it of necessaries, comforts or

luxuries, and of goods or services is called israf The point mentioned
above that the prospect for high rates of return in real investment in a
mudarabah system increases real investment and reduces relatively
consumption expenditure is found to control the practice of israf
A lower propensity to consume and a higher propensity to invest
negates the basis of the neo-classical consumption theory of interest.
A brief look at the Islamic investment-consumption behaviour is
warranted at this point:
(i) An Islamic society gives consumption priorities to the necessaries
and comforts oflife in this order. It is widely agreed upon by many
Islamic scholars that the production and consumption ofluxuries is
prohibited in so far as this is tantamount to israf
(ii) Excessive production and consumption of any type of good is not
recommended, for this creates wastage of factors of production and
of produced goods.
(iii) Savings in the form of real investment to produce the necessaries
and comforts of life and more capital goods that increase the
productive capacities in the following periods of time is highly
encouraged.
In an Islamic economy, therefore, the approach to the study of
intertemporal allocative efficiency of modem consumer theory is
replaced by the welfare analysis of income allocation predominantly
into real investment. A priority area of Islamic economic theory16
would therefore be Islamic welfare economics. One would first have to
develop carefully the axioms of a choice theoretic approach to
individual and social ordering, based on the principles of the Islamic
integrated value system, particularly as they apply to the issue of
investment-consumption allocation of resources.
18 Principles
Institution of zakah
One of the most important Quranic injunctions on Muslims is the

payment of zakah, that is, a capital tax on accumulated wealth. Zakah is
one of the five immutable pillars of Islamic faith. Literally, the word
zakah means sweetening and it is meant to purify wealth from its evil
tendency to accumulate more and more in fewer and fewer hands on
account of the unequal opportunities which men enjoy. Through zakah
the wealthy Muslims are made responsible individually and collectively
for providing for the basic necessities of all members of the society.
Islam does not object to the earning of large sums, but makes it a
bounden duty of the wealthy to see that not a single soul is deprived of
the basic needs of living.
A special economic significance of zakah is that it is the avowed enemy
of hoarding. A man's wealth according to Islam has to be spent partly on
the necessaries of living and comfort, in productive investment, in
charity, for the benefit of Muslims in general and in the way of God.
After these whatever remains standing for a year is liable to be taxed
under zakah. Zakah revenue consists of a levy of 2.5 per cent on all idle
wealth, one-tenth to one-twentieth of all agricultural produce, one-fifth
of all mineral wealth, and a tax on the entire earning from capital of the
nation. Zakah fund is payable: (I) to the poor, (2) to the needy, (3) for
the propagation of Islam, (4) for those in bondage, (5) for those in
debt, (6) for the wayfarer, (7) to the functionaries who collect and
distribute zakah, as their remuneration, (8) to other noble causes for
which money is required. It must, however, be clearly understood that it
is only the principle behind zakah that remains immutable in Islam, but
not so the ways of collecting and distributing it in the broadest possible
aspects of the eight categories of expenditure mentioned above.
CONCLUSION
The foregoing has been a brief outline of the principles of Islamic

economics. By the word 'principle' we have meant the fundamental
philosophy of this system of economics. This, therefore, does not
include the specific assumptions, or structure, or an exhaustive coverage
of the instruments of policy that would characterise the functioning of
the different sectors of the Islamic economy based on the above-
mentioned principles.
The principles of Islamic economics would playa major role in the
shaping of a new development programme for Muslim nations if they

are accepted as the new value system of economics. We conclude this
chapter by recommending that while Muslim nations are now at the
threshold of a new era in joint national science and technology
policies, 1 7 they should clearly identify their national priorities in social
values and link them soundly with their economic development
strategies. The harmonious blending of the two alone can put Muslim
societies on the path to a sustained, productive and meaningful
growth. l8 Reddyl9 has recommended the establishment of a New
International Economic Order for the fusion ofthe different objectives
of development with the social and ethical values that found societies. In
Muslim societies such values must inevitably be the Islamic values, and
any form of economic development must seriously consider the
potentials of Islamic economics as the basis of the New International
Economic order.
Part II
Microeconomics
Part II of the book develops the principal theory of microeconomics in the
Islamic economic perspectives. The work accomplished in this section is again
one on social economics in a broader analytical sense developed and analysed
within the framework of mainstream economics. The relevant assumptions and
conditions necessitated by shariah are mentioned wherever applicable.
In Chapter 2 we introduce the Islamic economic theory of consumer demand
for the individual. The material contained in this chapter is rigorously analytical,
as it builds upon a comparative approach to modem demand theory and utility
theory, considering the critical factor of 'irrational' economic decisions on the
part of the consumer. The word 'irrational' is invoked here as an antidote to the
time-honoured, but highly critical concept of 'rational' behaviour of the homo
economicus, embalmed in classical and neo-classical approaches to economic
analysis. Factors that are not purely of an economic nature, such as those
pertaining to religious injunctions on certain types of consumption preferences
given to human conscience, goodwill, altruism, etc., important as they are in
individual decision-making on economic matters, are comprised in an analysis
of the utility theory, leading thereby to consumer demand theory from an
Islamic economic perspective.
In Chapter 3 we discuss the logical counterpart of consumer theory - the
theory of the firm from an Islamic economic perspective. In keeping with the
approach of mainstream economics the principal topic discussed in this chapter
is the efficiency criterion of the firm in an Islamic economy. Thus, some basic
Islamic aspects of behaviour in the exchange mechanism are invoked-
competitive co-operation, and its impact on market economic transactions. The
offshoot of this is the central issue of the pricing theory of the firm in an Islamic
economy under the competitive-co-operative conditions and assumptions. The
approach in this chapter to the topic under discussion is thoroUghly analytical
and elementary mathematics is used.
In Chapter 4 a financial theory of the firm in an Islamic economy is
introduced. Here too the approach is of a comparative nature with the theory of
the firm in the conventional economy. The idea of mudarabah stocks, or Islamic
profit-sharing common stocks, is developed on a comparative framework
leading to the formulation and the analytics of the financial statements of the
Islamic firm. This is followed by a quantitative study of the Islamic firm's
financial statements in a comparative framework.
In Chapter 5 the role of zakah, the Islamic quasi-tax on wealth, on resource
allocation is discussed. A comparative study with the modem concept of
22 Microeconomics
resource allocation, efficiency and the theory of the second-best is made. The
chapter then uses the Islamic idea of resource allocation through zakah in a
social service model. It is then quantitatively examined in an Islamic cost-
benefit model applied to a zakah-funded training programme. Incomes data
required for this part are for Saudi Arabia.
In Chapter 6 the analytics of the workings of mudarabah, the Islamic profit-
sharing system, is developed. The principle of mudarabah is shown to play an
important role in risk diversification. The principles of zakah taxation and
mudarabah constitute the central instruments of resource allocation in Islamic
microeconomic theory.
In Chapter 7 the concept of utility and welfare maximisation in the Islamic
perspective, developed in Chapter 6, is further developed and extended to a
broader spectrum of decision processes - that of the firm, the organisation and
the state. The characterisation of the decision-making process in the Islamic
economy necessitates the discussion of a new concept of resource, cost, benefit
and the time dimension for evaluating decisions in the Islamic framework.
Special forms of optimisation criteria are introduced and then used to evaluate
the economic implications of decision-making in the Islamic framework, with
particular consideration being given to zakah and non-interest-discounting
methods.
In Chapter 8 the offshoots of consumer theory and decision theory at the
levels of the firm, the organisation and the state are extended to the Islamic
framework of welfare economics. The choice theoretic approach of an Islamic
welfare economics is developed and the nature of the Islamic social welfare
function discussed in a comparative economic perspective. The assumptions of
shariah, such as those of the Islamic socio-political state; ijma or consensus of the
Islamic community; taqwa or righteousness inspired by the fear of God; akhira
or knowledge of the divine judgement to follow after life; ibadah or Islamic
worship, etc., are treated as 'imponderables' in the Islamic social welfare
function. A comparative study of this approach to the choice theoretic approach
of welfare economics introduced by Arrow is made.
In this way, Part II of this book, on Islamic microeconomic theory, spans the
principal areas usually covered in a rigorous introduction to the theory of
microeconomics in mainstream economics. That is, we start with the analysis of
utility theory and consumer demand. Then we move on to the study of the
pricing theory of the firm under perfect and imperfect competition. Finally we
treat the subjects of resource allocation, the role of the profit-sharing rate in
optimal resource allocation, and social ordering in Islamic welfare economics.
The imputation of important 'imponderables' in these areas of study from the
Islamic viewpoint makes the study one of social economics as well.
2 An Islamic Approach to
the Theory of Consumer
Demand*
THE POSTULATE OF ECONOMIC RATIONALITY IN
CONSUMER DEMAND THEORY
The theory of consumer demand is steeped in the postulate of economic

rationality. This postulate states that, of all the consumption alternat-
ives available to an individual, he chooses the one that maximises his
gains. The same concept of economic rationality is extended to the case
of the producer and the organisation as decision-makers.
The gains that an individual wishes to maximise through his proper
choice of consumption menu could comprise of purely economic gains,
sheer measure of pleasure and avoidance of pain, or a mix of such
factors. The consumer thereby hopes to derive different levels of
satisfaction from the consumption of various bundles of items like,
goods, services, incomes, fringe benefits, job security, leisure and time.
The determination of the mix of consumption bundles of these items
that would lead the individual to consume in given quantities in order to
maximise his gains, evolves out of the constrained optimisation of a
mathematical function called the 'utility function'.
The optimisation of the utility function is therefore the offspring of
the postulate of economic rationality. A consistent set of consumer
behaviour is required to effect a well-defined utility maximisation
problem. The consumer behaviour so required are expressed in terms of
the following axioms. 1
(I) If the consumer is known to have two alternatives, A and B, and if
he derives more utility from alternative A than from alternative B, then
* An earlier version of this chapter was published in Islamic Order, vol. 6, no. 3, Third
Quarter, 1984.
23
24 Microeconomics
the consumer is said to prefer A to B. Thus, for all possible pairs of

alternatives, A and B, the consumer knows whether he prefers A to B, or
B to A, or whether he is indifferent between them.
(2) The mutual exclusiveness postulate states that only one of the
above three possibilities is true for any pair of alternatives.
(3) The transitivity postulate states that among three alternatives,
A, B, C, if the consumer prefers A to B, and B to C, then he will prefer
A to C.
A CRITIQUE OF THE POSTULATE OF ECONOMIC

RATIONALITY
The concept of economic rationality has been the target of intense

criticism from the time when utilitarian analysis entered economic
theory. We present here two competing critiques on the postulate of
economic rationality.
Utilitarianism, which was the logical offspring of the postulate of
rationalism fathered by Bentham, bequeathed to the world of econ-
omics, as if a natural law system. This natural law was treated by
Bentham as a unitary social science that was both normative and
analytical. 2 However, strong criticism to this law was voiced on grounds
of the alleged inadequacy of the system in explaining facts of the political
life and the way in which states, governments, parties and bureaucracies
actually work. Schumpeter comments that the utilitarian theory was
based on individualistic, empirical and 'rational' approach to
socioeconomics. However, 'individualism does not necessarily involve
empiricism or rationalism in this sense; empiricism does not necessarily
involve individualism and rationalism in this sense; and rationalism in
this sense does not necessarily involve individualism and empiricism'. 3
Another criticism of the postulate of economic rationality is voiced by
those who argue that households do not maximise anything; also, a
function if maximised is neither consistent nor transitive. 4 However,
Becker argues against this. S He proves that in the case of 'irrational'
behaviour by certain households characterised by impulsiveness or
inertness not abiding by shifts in average consumption opportunities
toward relatively cheaper commodities and away from more expensive
commodities the decision rule to consume would still be determined by
availability of the commodity. The constraint on the availability of the
commodity bundle, even in the absence of the decision rules based on
relative commodity prices, would still be negatively sloped. This point
Islamic Approach to Theory of Consumer Demand 25
imparts a message of vital importance to Islamic economic theory of

consumer demand. The message is that results of economic theory would
remain unchanged in the more general sense where the market consists
of rational as well as irrational decision-makers.
In the above discussion the term 'irrational' is being used as an
antidote to the traditional neo-classical concept of rationality that
pervades mainstream economics. The term 'irrational' behaviour is
assigned to consumers here to signify that they do not necessarily and
only optimise their own interpersonal utilities based on consumption
bundles. Nor do individuals necessarily increase their demand for
certain commodities if the relative prices of these commodities decline -
even in the case of substitutes. Some examples from Islamic economic
behaviour of consumers can illustrate these points: a decline in the price
of gold cannot be allowed to ensure an unlimited demand for holding
gold. The Islamic state will intervene here and arrest any expected
devaluation of its currency and thereby interrupt individual incremental
demand for holding gold. Likewise, a decline in the price of a substitute
cannot be allowed to create an unlimited demand for it lest this creates
excess demand in the form of wasteful consumption. Such consumption
characteristics can be considered as abberrations to the accepted
'instability' postulate of traditional consumer theory. These and similar
characteristics are therefore referred to in this book as being 'irrational'
with respect to the traditional economic basis of rationality.
AN ISLAMIC THEORY OF CONSUMER DEMAND
In the Islamic economic theory of consumer demand 'imponderables',

i.e. ethical considerations in decision-making, enter as important
consumption bundles of the traditional 'non-economic' type. Such
factors distort the consistency and transitivity axioms of economic
rationality in the absence of any related price mechanism. For example,
a true Muslim obtains great felicity by allocating a part of his monthly
expenditure budget as donations to a mosque. He can expect no
monetary return from this act. His motivations are singularly based on
the tenets of his belief. Thus, one can associate no direct pricing
mechanism to this act relative to the purely economic factors of his
consumption menu. Therefore, no economic consistency criterion in the
known sense of the terminology can be readily imparted to such
individual choices. The non-existence of a price mechanism for 'ir-
rational' behaviour does not mean that a proxy cannot be made. In fact
26 Microeconomics
proxies for such invisible prices can be imparted by assigning ordinal

weights or by conceptualising inverse demand functions associated with
these 'goods', so that a proxy price can be generated as a dependent
variable in terms of the levels of these 'goods' consumed. 6
Decisionastic determinism of this type is of course found in most
ethical systems. Arrow speaks about the role of human conscience and
welfare to fellow men in the process of donating blood. The role of a
social contract in economic activity is thereby formalised in relation to
individual ethics and values. Arrow's formulation of individual utility
function including 'imponderables' explains the welfare of each individ-
ual in a social contract as being dependent on both his own satisfactions
as well as on the satisfactions derived by others. This is a strong
implication of the condition for a positive relation of altruism rather
than of sheer competition, as a necessary one for resource allocation in
the context of interpersonal maximisation of utility.
Man being essentially a social being the Islamic notion of inter-
personal utility maximisation is closer to the Arrow type of implied
interdependent utility maximisation problem. In this context man, by
maximising his own interpersonal utility is really doing so through the
social contract of dispensing altruism to others. In such an altruistic and
co-operative condition of resource allocation the welfare gained by each
individual is shown to depend not only on his own utility index and those
of others involved in the social contract, but also on his contribution to
the utilities of others. Each individual is shown to be ultimately
motivated by purely egoistic satisfaction derived from the consumption
of goods and services to him in ways that each member performs duties
for the other calculated to enhance the satisfaction of all. 7
The Islamic conditions of altruism in consumption behaviour are
similar to the kind of utilitarian social contract explained above.
However, Islamic constraints on wasteful consumption; prohibition of
certain forms of consumption, such as of alcohol, carcass, forbidden
animal; moderation in the consumption of luxuries; prohibition of
consumption based on interest income; encouragement on expenditures
in goods and services for basic needs; and on philanthropy, are built into
the income constraints for utility maximisation of joint altruistic forms
of interdependent utility functions including 'imponderables'.
The essential difference between the Western and Islamic economic
formulation of 'irrational' behaviour in economic theory that is noted
here is that consumption 'stability' axiom, patterns of consumer
demand for investment goods and other goods by society constrain the
consumption set of the individual in an Islamic economy. Thus the
presence of 'irrational' consumer behaviour in the sense defined earlier,

becomes a necessary characterisation of the Islamic consumption set.
This is, however, not true of the consumption set in traditional
consumer theory, even when the 'irrational' conditions are sometimes
imposed.
The Islamic view on consumption-investment behaviour is fairly
straightforward. The Islamic Law has the following hierarchy of
preferences on the consumption -investment menu in an Islamic society:
(l) Consumption of and investment in the production of essentials,
comforts and lUxury are encouraged in this order of preference, subject
to the condition that it does not create wasteful consumption.
(2) Consumption of and investment in the production of goods and
services prohibited under Islamic Law are strictly forbidden in an
Islamic state, unless necessary, such as, for example, the manufacture of
alcohol and sedatives for medicinal purposes, acquisition of the
metaphysical sciences as a requirement for the comparative study of
positive sciences, and so on.
(3) Investment in real capital that increases the productive capacities
in subsequent periods of time is highly encouraged.
The 'imponderables' of an Islamic utility function comprise factors
from the Islamic ideas of resource, cost and benefit. Among the
imponderables included in the Islamic idea of resource are the worldly
equivalents of the resources of Islamic belief, in so far as these augment
economic and social activities. An example of this type of resource is
zakah or capital tax of an Islamic state. Zakah constitutes an organised
form of social assistance. The readiness to pay it on the part of the
individual stems from his strength of Islamic belief and not from the
coercive action of the state in the first place. However, the imperative
attached to the mandatory payment of zakah in an Islamic state is so
great, that in the event of default, an organised Islamic state can realise
the payment of zakah by force from the evaders. Islamic history records
such instances where the state used its force to realise the payment of
zakah from contenders. 8 The flow of resources from zakah is therefore, a
positive function of the progressive degree of Islamic transformation in
the society. On the other hand, the worldly equivalents of this Islamic act
show up in the realisation of the direct as well as the external benefits of
income redistribution, increased levels of training for the needy, reduced
levels of structural unemployment for the underprivileged and so on.
Such a blending of economic values with the 'imponderables' in an
Islamic framework of decision-making is brought out in the following
28 Microeconomics
words of an Islamic writer: 'The basis of an integrative or systematic

approach to Islamic values distinguishing between universal goals and
specific applications on the other hand (so as to) define the hierarchy of
values in Islamic LaW.'9
The Islamic idea of cost includes both economic as well as 'non-
economic' costs. Among the 'non-economic' type of cost is the Muslim's
Islamic realisation of the impending punishment in the hereafter that
would result from his indulgence in wasteful consumption in this world.
The degree of his punishment in the hereafter, and thereto the
progressive strength of his belief to avoid wasteful consumption in this
world are determined by the measured degree of cost resulting from the
act of wasteful consumption.
The Islamic idea of benefit is likewise, the sum total of the pure
economic and the 'non-economic' benefit elements. An example of the
worldly equivalent of factors of Islamic belief that constitute the non-
economic aspects of the total benefit is the level of productivity,
employability and income distribution resulting from the altruistic
programmes funded by the proceeds of the zakah fund.
The important point to note in this formulation of Islamic decision-
making in an utilitarian plane is that Islamic 'imponderables' enter the
utility functions as well as the income and resource constraints as
essential variables. These variables, on the other hand, are measurable
through their transformation into socioeconomic values. We thus return
to Becker's theory of 'irrational' behaviour in that traditional 'non-
economic' behaviour in economic theory, ifit can be integrated with an
interdependent system of utility functions, and be proxied values in the
income, resource, cost and benefit constraints, can still generate a logical
theory of price and quantity relationship - one which is negatively
sloped. Hence, an Islamic theory of consumer demand, signifying an
integrated approach to Becker's theory of irrational economic be-
haviour and Lancaster's characteristic theory of consumer demand. 10
It is now clear to note that the presence of altruistic and ethical
considerations in the consumption menu of each individual in society
can generate externalities in an intertemporal framework of resource
allocation. The concept of economic efficiency broadens. It is now to be
conceived in terms of a wider set of 'goods' and 'bads' whether
marketable or not, and accruing over time and affecting future
generations. The pattern of time consumption of external benefits
resulting from 'imponderables' in the individual utility function can be
linked to that of collective-consumption good. 11 The argument for-
warded here is that consumers demand certain collective-consumption
goods, not necessarily for self-consumption, rather for gaining felicity

through their acts of providing in charity. The public sector in the first
place can produce such goods. But here they tum out to be quasi-public
goods, whereby some consumers remain under-satisfied. The private
sector, on the other hand, can try to mitigate some of the under-satisfied
demand of consumers, by producing collective-consumption goods. But
this again is not without cost to the consumers. An adjustment process in
the provision of collective-consumption goods between the public and
private sectors thus leads to a socially suboptimal allocation of
resources. A voluntary non-profit sector, like the ones provided by the
socio-religious and ethical machineries in an Islamic society would
therefore serve to establish a global equilibrium process in the provision
of collective-consumption goods.
The reformulation of the utility criteria in terms of quantifiable
imponderable variables, and the possibility of considering these empiri-
cally in the income, cost and benefit constraints, now facilitates the
formalization of the demand theory in Islamic perspectives. To this
topic we now tum.
Figure 2.1 explains the price-quantity relations arising out of a static
framework of allocation of resources for a single individual in an Islamic
utilitarian plane. The quantity axis, denoted by q, denotes measure-
ments for the total quantity including economic as well as 'non-
economic' benefits. The price axis, denoted by p, denotes measurements
for the total cost, including economic as well as 'non-economic' costs.
Few examples of the pure 'non-economic' benefit are job security, social
security, income redistribution, better citizenship. Few examples of
'non-economic' cost are the price payed for consuming an additional
unit of the 'non-economic' good, such as, in the form of zakah-rate, and
the interpersonal social sacrifice entailing benefits of social consump-
tion. The point, q~, denotes the maximum amount of consumption
sustainable under the constraint of avoiding wasteful consumption. The
implication here is that the provision of collective-consumption goods
by the voluntary non-profit sector of the Islamic economy is not without
tangible cost, which after a point becomes heavy on the individual.
Thereafter, Islam would not recommend fut:ther sacrifice on the
individual at the expense of his own material well-being. Consequently,
the maximum price range is denoted by Po. This point is consistent with
shariah. Straight-line curves denoted by S1' S2' represent the levels of
felicity attained by the Islamic individual as a result of a given
configuration of price-quantity relation for an individual in the Islamic
society.
30 Microeconomics
p (q')
Po (qo')
' ..........
--------~------~~----~Sl
..... To
--:::::::--~-Q
o qo T q'Q q
FIGURE 2.1 Price-quantity relationship in an Islamic framework. and

indifference curves comparison with the conventional consumer behaviour
Dotted figures denote the situation for the consumer-indifference curves in the conven-
tional economy. Note that the same Figure 2.1 is being used for explaining both the
demand configuration as well as the indifference curves.
The levels of S1 and S2 are merely ordinal in nature. They are not
quantific in nature, rather only indicative. Their functional significance
is indicated by the fact that an individual in a pure Islamic society will
consume a higher quantity as a sum total of the pure <economic' and
'non-economic' goods by paying (sacrifising) a higher level of prices for
pure 'economic' goods and higher Islamic sacrifices for 'non-economic'
goods. Both of these in the price-quantity sense yield felicity to the
individual. Thus S1' S2 are implied to denote higher levels offelicity to
the individual.
Our earlier formalisation of the demand configuration in the presence

of quantifiable 'imponderables' in the income. cost and benefit as well as
the utility functions suggest that the general price-quantity relationship
will be negatively sloped. This is indicated by the curves like QQ. Note
that no such curve can extend beyond the vertical straight line q3 B.
Points denoted by (q1' P1) and (qo. P2) on the demand curve QQ.
indicate that a higher social felicity on the curve and denoted by S2' is
attainable by a decrease in consumption and an increase in sacrifice by
the individual. This may not, however. be true under alternative forms
of resource allocation. For example, it may be equally possible to attain
the same level of social felicity denoted by S2 by increasing one's
interpersonal level of pure 'non-economic' satisfaction, denoted by the
point, q2' while undertaking the same level of cost, denoted by the price
of the sacrifice, P2. In this case we have a point like (Q2' P2)' through
which, now passes a new demand curve Q' Q', and implies a higher level
of satisfaction both for the individual and society.
The process thus described can repeat itself yielding a continuum of
demand curves as shown. The demand curves must finally end up in a
point denoted by B. This is the bliss point wherein the individual as well
as society are in the maximal sustainable level of felicity attainable by a
given state of resource allocation explained by the price-quantity
relation. The optimal path of attaining bliss is denoted by the curve
passing through the points of intersection of the consumer demand
curve with the social felicity curve. A homothetic transformation of the
demand curves would give the optimal path of attaining bliss. Because of
the restraint in wasteful consumption working on the demand side it is
very possible that the bliss point in the Islamic economy will be attained
quicker than in the Ramsey-type economy.ll
Tangents denoted by the straight lines TT, T' T', etc., to the optimal
points on the demand curves represent the Islamic price lines. It is clear
from the definition of the price and quantity axes, which now include
'imponderables', suitably transformed into measurable values, that the
price line will account for the social pricing of these 'imponderable'
factors as well as the usual pure economic factors of the expenditure
function.
The curves shown by QQ, Q'Q', etc., can also be interpreted as the
consumer-indifference curves if we change the axes of Figure 2.1 to mean
quantities demanded (q) and quantities sacrifised (say if). Then the
straight-line curves, TT, T'T', etc., are income constraints. Other points
and results as derived above remain undisturbed. That is, under
restrictive ethical conditions imposed on the consumption set of the
32 Microeconomics
individual, as in the case of the Islamic consumer behaviour, bliss is

attained in finite time for the society, and possibly quicker than in the
case of the Ramsey-type economy. This may also be interpreted as the
result of the duality between ordinary demand functions and indirect
utility functions in the context of direct utility functions. That is, given
ordinary demand functions we can define the indirect utility function in
terms of these. Vice versa, given the normalised prices as functions of
commodities (inverse demand functions) it is possible to define the direct
utility functions. 12
When the price label is replaced by a substitute quantity in Figure 2.1,
we can then interpret it in the jargon of conventional consumer theory in
the following way: with To 1'0 as a new income line to the indifference
curve, Q'Q', the movement ofa point on QQ, say 0 1 , to the point 04,on
the new indifference curve involves a substitution effect signified by the
movement from 0 1 to 0 3 , and a price effect signified by the movement of
the point, 0 3 to 0 4 , One must note here, as shown in Figure 2.1, that
with respect to the conventional consumer behaviour, a point O 2 on the
Islamic consumer-indifference curve corresponding to the higher level of
ethical felicity denoted by S2' becomes an 'inferior good' point for the
conventional consumer. There is, therefore, the possibility for a point of
higher felicity in the Islamic consumer-indifference curve to be an
'inferior good' point for the conventional demand curve. This is
understandable when we consider that in the Slutsky equation ethical
considerations are not included in the price-quantity relations.
3 First-order Efficiency
Conditions of the Firm
in an Islamic Economy
A COMPARATIVE ECONOMIC DEFINITION OF RESOURCE
Economics is traditionally defined as a study of scarcity of resources and

of the problems created by scarcity. Under such a definition if goods and
services were to be abundantly available, then there would be no need for
economics to study the production, distribution and consumption of
economic resources. Thus, economic goods are treated as those goods
which are scarce. By the same definition therefore, goods which are
abundantly available would be referred to as 'non-economic' or 'free
goods'.
A fundamental principle of Islamic economics is that God is the
Creator and Custodian of whatever belongs to the heavens and the earth,
and He has made the resources for the service man. Also, He has
instructed man to use the resources in the strict absence of waste and for
establishing co-operation among his fellow men. This principle of
Islamic economics extends the definition of economics. The principle
implies that God provides sustenance to all creatures on earth and the
natural resources have been created by God in abundance to meet the
needs of all worldly creatures. Man's estimate of scarcity of resources is
the result of his limited knowledge of the diverse ways to use the
resources at his disposal. Therefore, in the Islamic concept of economics,
those goods which can be produced by human efforts are to be classified
as economic goods. On the other hand, those goods which are still
beyond man's known productive capacity, are to be classified as 'non-
economic' goods. The distinction between economic and non-economic
goods is thus based on the condition of availability or non-availability of
human involvement in the productive process. Such a definition of a
resource in the Islamic economy is therefore at variant with the
traditional economic concept based on the presumption of scarcity.
33
34 Microeconomics
THE BASIS OF A COMPETITIVE-CO-OPERATIVE

CONDITION FOR THE FIRM IN THE ISLAMIC ECONOMY
The principle stated above also contradicts the role of competition and
the principle of profit maximisation as the core of economic analysis. The
strong implication of co-operation in the Islamic principle, while at the
same time encouraging a market economy signifies that the first-order
efficiency conditions of an Islamic economy must be based on a balance
between competition and co-operation in all market transactions. 1
On the side of economic competition all profits in the Islamic
economy would be normal profits. 2 This is essentially due to free entry
and exit of firms from the economy as a result of economic competition.
Imperfect competition, characterised by monopoly, cannot be sustained,
because the Islamic entrepreneur is not allowed by Islamic Law to
control prices or output and to gather undue surpluses. 3
On the side of economic co-operation the Islamic institution of
mudarabah protects weaker firms from going bankrupt and exit from the
market. The principle working here is that, by sharing in the total cost of
production, the mudarabah partners tend to counterbalance the total
cost of production in case oflower competitiveness by any single partner.
PRICING THEORY OF THE FIRM IN AN ISLAMIC ECONOMY
Mathematical Formulation
We shall now show that the pricing of the product by the firm in an
Islamic economy is determined by the average total cost, which in turn is
controlled by the level of output made possible in any subsequent cost-
sharing condition under mudarabah. It is well known from theory that
the price function itself is determined by the average-revenue curve, i.e.
by the demand curve. It will therefore be shown now that, for the general
case of a firm in the Islamic economy, the first-order conditions of
efficiency of the firm in the Islamic economy are given by,
P = AR = ATe.
This is a result we shall now derive analytically. Special cases of this result
in relation to the first-order conditions of efficiency of the conventional
firm in theory will follow. An analogue of the above condition is also
explained by Samuelson. 4
Islamic economic principle says that a firm cannot be allowed to earn
First-order Efficiency Conditions of the Firm 35
inordinate amount of profits through monopolistic competition and

must restrain from wasteful production as well as from excessive capital
consumption. This principle therefore suggests that an appropriate
economic objective criterion for the firm in an Islamic economy would be
cost minimisation subject to profit constraint, and not vice versa. We can
then formulate the firm's optimisation problem in the Islamic economy
as follows: s
L riXi,
n
subject to 7t = pq -
i= 1
where C denotes cost function,

q denotes the level of output of production by the firm,
Xi denotes the quantity ofthe ith input of production for the firm,
i = 1,2, ... ,n.
7t denotes the constrained profit level for the firm,
P denotes the selling price of output,
ri denotes the price of the ith factor of production,
i = 1,2, ... , n.
Now by introducing the Lagrangian L and the Lagrange Multiplier, A,
the optimisation problem takes the form
min L = min [C(q, X, X2, ... ,XII)+A(pq - it1 rixi )]
The first-order conditions of minimisation are

oL OC
oq = oq + AP = 0 (1)
oL oe
- = - - ) . r · =0 (2)
OXi OXi I
i = 1,2, ... , n
oL
L r·x· = 0
II
- = pq - (3)
0). i= 1 I I •
From equations (1) and (2) we obtain

OC/oq p
OC/OXi = -;;
36 Microeconomics
dXi
i.e. P = ri dq·
dq
i.e. ri =p·-
dXi .
Since Xl, X2, ... , Xn are independent variables, therefore

dq aq
- = - , i = 1, 2, ... , n,
dXi aXi
rixi Xi aq
or that is, -=p._.-
q q OXi
L L
n n ~
and riXi =p. Xi.~,

i= 1 q i= 1 q OXi
n
i.e. ATe =p L '1i,
i= 1
n
where '1i denotes the input elasticities, with L '1i = 1.
Therefore p=ATC (4)

Also from equation (3) we obtain
n
qp
L riXi
i=l
-=
q q
i.e AR = ATe.
Hence the Islamic efficiency pricing conditions, or that is, the first-order
efficiency conditions, are established
p = AR = ATe. (5)
This result can be given the Islamic economic meaning that factors of
production, such as, labour, owners of capital and resources, joint
enterprisers, etc., become mudarabah partners in the Islamic firm. They
share the average cost of production (and therefore investment) and reap
the average benefit through payments of their wages and dividends.
These payments occur through product pricing. In a competitive~o
operative economy therefore, product prices have to be set by the firm
such that, p = ATe. Therefore both p = ATe and AR = ATe as shown
above.
The general case of the first-order efficiency conditions of the Islamic

firm is shown by Figure 3.l. The pricing of the product at the point
(q1 ,P3) is a case of monopolistic competition. This configuration of the
price-quantity relation is therefore ruled out for the Islamic firm.
However, by introducing co-operation along with competition for the
Islamic firm, the condition of perfect competition is thwarted too.
Therefore price-quantity determination in perfect competition is also
ruled out. The price--quantity relation is midway between these two
cases. This is shown by the point, (q2, P2) as the general case of
price-quantity determination for the Islamic firm.
Figure 3.1 also shows that in the case of the Islamic firm operating
under competitive-<:o-operative conditions it is possible to produce at a
higher quantity level, q2, and still sell at a lower price level, P2' than the
corresponding case of monopolistic competition for the other firm,
whose quantities sold are constrained at the level, q 1, and the selling price
is at the level, P3.
Relative prices for the Islamic firm's product given by pdp1 is greater
than unity to the extent of the price elasticity of demand, because in the
case of mudarabah partnership the firm will have to diversify its risk by
building up a marginal price cushion. In other words the profit rate must
be sustained high enough to protect the liabilities of the individual
partners and thereby to sustain co-operation among them.
It is also interesting to note, that equation (2) can be extended and
written as
oC;OX n
=--- (6)
r1 r2
This is also equivalent to
Oq/OX1 Oq/OX2 oq/ox n
- - - = - - - = ... = - - - (7)
Expression (7) is well known as the equilibrium marginal productivity

condition of inputs. Expression (6) conveys something new. That is, an
increment in the cost due to a unit increase in the inputs is proportional
to the payments to these inputs. Expressions (6) and (7) are equivalent.
Combining the two yields the identity
C=q. (8)
Equation (8) is again a version of the Euler theorem on product
exhaustion, stating that the total output is fully exhausted by marginal
productivity payments to all the factors of production. 6 In equilibrium
~
00
Price Price Price
MC MC
MC ATC
p I ............ I r#"":
Pd ........... .,,-
AR
MR
q, q2 Quantity q Quantity q, q2 Quantity
FIGURE 3.1 FIGURE 3.2 FIGURE 3.3
Pricing mechanism of the firm in an Islamic economy

the total marginal productivity payments to all factors of production

would therefore equal the cost of production. Thus, equations (6), (7) and
(8) are equivalent to each other in the state of optimal resource allocation
by the firm in an Islamic economy.
Equations (3) to (6) are applicable also in a competitive economy
under co-operation among the factors of production including man-
agerial participation. Therefore, we must now give the special cases
whereby condition (4) of the general first-order efficiency conditions of
the Islamic firm can be alligned to the first-order efficiency conditions of
the conventional firm.
Special Cases of tbe First-order Efficiency Conditions of tbe Firm in an

Islamic Economy
The average-revenue curve being identical to the demand curve for the
firm's output it may be negatively sloped, horizontal or vertical. It is also
not necessary for the average-revenue curve to intersect the marginal-
cost curve at the minimum point of the average-cost curve. Thus, special
cases arise in the following instances:
Case 1: AR is tangential to the ATC curve.
This is shown in Figure 3.2. In this case the first order efficiency
conditions of the Islamic economy are identical to those of the
conventional economy, i.e.
p = AR = M R = min ATe. (9)
Case 2: AR intersects the ATC curve.

Figure 3.3 shows that in the case where below-normal profits are being
earned it is possible to sustain the price level and then sell a higher level of
output. In this case the output level, Q2, is the only feasible output level.
In the formalisation of the first-order conditions of efficiency for the
firm in the Islamic economy two other points are to be noted. First, the
condition, AR = ATC, implies that revenue equals expenditure. That is,
the firm uses all its liabilities to finance its assets. Thereby an optimal
capacity is sustained in the firm's production process. Second, the profit-
maximising condition of the conventional economy, i.e. an M R equal to
MC as in the case of perfect or monopolistic competition may not be
true. That is, MR +- MC for the Islamic firm, on the grounds that
according to Islamic Law monopolistic competition is forbidden, and
because we are now operating in a competitive~o-operative situation.
4 Introduction to the
Financial Statement
of the Firm in an
Islamic Economy*
A COMPARATIVE LOOK AT STOCK FINANCING IN A
CONVENTIONAL AND ISLAMIC ECONOMY
An elementary idea of the capital structure in an Islamic economy will be

introduced in this chapter. The proper place to begin is by investigating
the nature of stock financing in an Islamic economy, for it is in this area
that we can discuss the important topic of debt-equity nature of capital,
which plays a significant role in the Islamic economic theory of capital
formation at the level of the firm.
In the conventional economy preferred stocks have a fixed dividend
rate within a maturity period, unless it is called back or converted.
Dividends on preferred stocks must be paid to the shareholder whether
or not the corporation made profits. Thus, in the Islamic perspective
preferred stocks come under the category of financial items for which
financial returns are fixed at the time the item is purchased. Thereafter
the shareholder does not participate in the risk of the financial venture
that he has made. On the other hand, the risk is totally passed over to the
corporation selling the promissory note, for a payment equal to the face
value of the preferred stock.
This mode of financial transaction involved in a preferred stock is not
admissible in the Islamic perspective of stock financing. There are two
reasons for this. First, the fixation of the dividend rate for the entire
maturity period is tantamount to riba or interest. Secondly, by
underwriting its risk with an individual or financial intermediary, for a
* An abridged version of this chapter was published in Arab Gulf Journal, vol. 5, no. I,
April 1985.
40
Introduction to Financial Statement of the Firm 41
fixed payment, the corporation tries to secure the incidence and

magnitude of the risk. The risk here is tantamount to economic
uncertainty, and can therefore be at best subjectively estimated.
On the other hand, the method of deficit financing by issuing common
stocks appears to be acceptable in the Islamic framework. It is well
known that common stocks build up equity capital in a corporation.
They do not carry a fixed rate of dividend or even the guarantee that a
dividend could be paid at each period of time within the maturity period
of the common stock. Such an arrangement with common stocks implies
that the corporation and the stockholder would jointly participate in the
risk and profits of the financial venture. This is similar to the Islamic
system of profit- and loss-sharing.
However, there is more involved in this method of financing. The
dividend rate on a common stock is determined competitively to the
market rate of interest. Besides, common stockholders are mostly
owners, directors and management of corporations. Therefore, the base
of equity capital is still limited to a preferred class of stockholders. This
is deliberately done by the corporation so as to limit effective control of
decision-making in it to the preferred group of decision-makers. The
sole interest of these decision-makers is to maximise the value of the
common stocks.
MUDARABAH STOCKS AND SHARES
In this comparative perspective of preferred and common stock

financing we can now introduce the Islamic idea of mudarabah stocks
and shares. We shall first explain the idea of mudarabah and its role in
the financial statements of a firm.
In a capital-using enterprise mudarabah denotes a profit-sharing
system, whereby partners in a joint investment venture advance agreed
amounts of capital on the contractual agreement to share the profits of
the joint venture by preassigned percentages. The preassigned per-
centage shares of profits are determined by relative shares of capital
advanced by each partner. The institution of mudarabah is important in
an Islamic economy because it completely replaces interest transactions
on capital by the function of profits. The rate of profit replaces the rate
of interest.
The complementary to the mudarabah system is the risk- or loss-
sharing system as well in the Islamic economy, known as shirikah.
Shirikah encompasses both profit-sharing as well as risk- or loss-sharing
42 Microeconomics
in an Islamic joint venture. The technical implication of the difference

between mudarabah and shirikah is that the principle of mudarabah in
economic analysis is appropriately applicable to the valuation of assets,
whereas the principle of shirikah is appropriately applied in assessing the
current state of the assets and liabilities, i.e. in the balance-sheet of the
corporation. This is obvious because according to capital valuation
requirement, the rate of profit would never be negative. Hence, the
relevance of mudarabah. On the other hand, in the balance-sheet or the
income statement of the firm, the rate of profit between subsequent years
could show to be a negative quantity. Hence, the relevance of shirikah.
It therefore appears that the principles ofmudarabah and shirikah are
both applicable in the case of stock financing in the Islamic economy.
Such stocks are closer to common stocks, when not linked to interest
rates or to the minority effective control of the corporation. They are
termed in this chapter as mudarabah stock or shares.
One must take note, however, that because mudarabah shares, like
common stocks, would put more risk on the shareholder than preferred
stocks, therefore, the Islamic economy must generate necessary controls
and incentives to make such stocks and shares attractive to prospective
shareholders. This can be done by using the institution of mudarabah to
effect risk diversification, and through this in generating confidence on
higher prospective rate of return than interest-bearing securities.
NATURE OF THE BALANCE-SHEET AND THE INCOME

STATEMENT OF A FIRM IN THE ISLAMIC ECONOMY
We can now look at the structure of the balance-sheet and the income
statement for a firm in an Islamic economy. The principle of these
financial statements of the firm in an Islamic economy remains the same
as in the conventional economy. However, many of the items in these
statements take different meanings and relations.
On the side of current liability there is no interest cost of short-term
and long-term debts. Rather, in the short-term debt, loans can be
charged an administrative price and placed against a suitable collateral.
Strict surveillance is maintained on the purpose of the loan. Only
working capital, needs-oriented consumption loans and developmental
loans may be considered to qualify for financing. The long-term debt is
totally replaced by equity capital. Consequently the debt cost of capital
on the equity is replaced by the share of the rate of dividend on
mudarabah shares. The principle of mudarabah may also apply in the
short term, when, for example, money capital is transacted in the form of
certain hard currency that may appreciate in the short run. The total
calculated amount of convertible currency appreciation or depreciation
on the loaned money capital in hard currency would then be borne by
the borrower to the lender, or by the lender to the borrower, as the case
maybe.
Taxes on the firm in the Islamic economy can be oftwo types. Zakah
constitutes a flat-rate taxation on the total income yielding assets of the
firm. The rate is usually taken as 2t per cent, but may vary among
categories of items being zakated. Other forms of taxes are also
permissible in Islam. Such as, additional taxes could be levied for
pollution control, on unused lands and machinery deemed feasible for
current usage, on the production of luxuries, education tax, property
tax, etc. It should be noted, however, that all additional taxes are to be
considered as residual to zakah. In the balance-sheet of the firm taxes
would enter as short-term liability.
Since mudarabah shares, unlike common stocks, can be bought by the
common public besides owners, directors and management of a
corporation, therefore the objective of maximising the value of the
shares of mudarabah stocks assumes a social perspective. The recom-
mended objective criterion for the firm would now be the maximisation
of the net worth of the firm, that is, maximising the difference of the
value of current assets to current liabilities. Such an optimisation
objective is favoured because it would indicate the level of investment
propensity attainable by the firm in an Islamic economy, characterised
as it is by a high propensity to invest in real capital, in the presence of its
specific consumption-investment menu.
Turning now to the income statement for the firm in the Islamic
economy, we notice that debt-financing item will be replaced by
mudarabah-type financing. Net income shown in the income statement
would equal net operating income less dividends on mudarabah shares.
Therefore, net income is the same as the retained earnings for the firm in
an Islamic economy. After this accounting step zakah is levied on the
retained earnings. Other taxes may also be levied at this pdint.
This system of post-retained earnings taxation in the Islamic economy
as opposed to pre-retained earnings taxation in a conventional economy
is found to yield a higher increase in dividends. To prove this,
Let denote a flat tax rate in either case of the conventional

and the Islamic economies,
R(q) denote revenue from sales,
C(q) denote total operating cost,
D*(q) denote cost of debt,
44 Microeconomics
Dj(q) denote dividends in the two cases of taxation method,

i = 1, standing for the pre-retained taxation method,
i = 2, standing for the post-retained earnings taxation
method.
In the case of pre-retained earnings taxation method, profit is given by
1tl = (1 -t) [R(q) -C(q) -D*(q)] -Ddq)
In the case of post-retained earnings taxation method, profit is given
by
1t2 = (1 -t)[R(q) -C(q) -D2(q)].
Now, optimising profits by increasing production (i.e. output) is

shown by the first-order optimal conditions
O~l = (1 -t)[R'(q) -C'(q) -D'*(q)] -Dl (q) = 0
and °O~ = (1 -t) [(R'(q) -C'(q) -D 2(q)] = 0,
i.e. DI'l (q) = D2 (q) - D'· (q),

-t
where, °~ t < I and D'· (q) > 0, D'l (q) > O.
The expression D'* (q) > 0 means that in a profit-maximising firm the
goals of optimising output and net operating income are complementary
to increasing levels of debt capital. It is also being assumed that dividends
are increasing in each of the two cases of taxation methods.
Therefore, D2 (q) > D'l (q).
This expression proves our theorem that, with increasing levels of
output in a firm, the method of taxing post-retained earnings yields a
higher increase in dividends than the method of taxing pre-retained
earnings. While this result is true in general, it applies in particular to the
firm in the Islamic economy.
A QUANTITATIVE STUDY OF THE FIRM'S FINANCIAL

STATEMENTS IN AN ISLAMIC AND CONVENTIONAL
ECONOMICS
A comparative quantitative study of the characteristics of the financial

statement for the firm in an Islamic economy can now be made. The
following income statements for a firm situated in an Islamic and a

conventional economy bring out the differences in some of the financial
characteristics.
The following financial information are given for a firm X situated
either in an Islamic economy or a conventional economy. The period for
the financial statement is 1 July to 31 December 1983.
Administrative expenses $ 30000

Depreciation charges $ 30000
Direct labour cost $ 70000
Factory overhead cost $ 35000
Interest and debt payments $ 40000
Materials purchased $115000
Annual rate of interest 10 per cent
Annual rate of service charge
on loans 3 per cent
Mudarabah dividend payout ratio 40 per cent
Income-tax rate on the firm 2.5 per cent
For the firm X when situated in an Islamic economy there would be no

interest payments. Interest rate will be replaced by a service charge on
loans. The method of income taxation in an Islamic economy is based on
the income net of dividend payments. In the conventional firm this is
based on income net of taxes and precedes dividend payments.
The amount in interest and debt payments is reduced to a service and
debt payments in the following way:
Let P denote the principal amount before interest payments,

i denote the annual rate of interest.
Then 40000 = P(l + i)!.
P' denote the final payment with service charge,
Let P' denote the final payment with service charge,
s denote the annual rate of service charge administratively set.
Then, P' = P(1 +s)t.
With i = 0.1 0,
P = 40000/(1.10); = 38139.
With s = 0.03,
P' = 38139 (1.03)! = 38707.
The income statement for the firm X when situated in an Islamic
economy is now constructed as follows:
46 Microeconomics
INCOME STATEMENT I
COMPANY X
1 July-31 December 1983
$
1. Revenue from sales 400000
$
2. Less: administrative expenses = 30000
depreciation charges = 30000
direct labour cost 70000
factory overhead cost 35000
materials purchases =115000
Total operating cost =280000 280000
3. Equals: net operating income 120000

4. Less: service charge and debt payments 38707
5. Equals: pre-dividend income 81293

6. Less: mudarabah dividend payments (40 per cent payout ratio) 32517
7. Equals: pre-zakah income 48776

8. Less: zakah levy (2.5 per cent of pre-zakah income) 1219
9. Equals: retained earnings 47557
The income statement for the firm X situated In a conventional

economy is the following:
INCOME STATEMENT II
COMPANY X
1 July-31 December 1983
$
1. Revenue from sales 400000
$
2. Less: administrative expenses = 30000
depreciation charges 30000
direct labour cost 70000
factory overhead cost 35000
materials purchased = 115000
Total operating cost = 280000 280000
3. Equals: net operating income 120000

4. Less: interest and debt payments 40000
5. Equals: pre-tax income 80000

6. Less: taxes (2.5 per cent of pre-tax income) 2000
7. Equals: net income 78000

8. Less: dividend payments-(i) $32517 (same as in Islamic

economy) (i) 32517
(ii) $27 300 (at 35 per cent of net

income) (ii) 27300
9. Equals: retained earnings (i) 45483

(ii) 50700
Line (6) of the Income Statement I conveys the fact that once a
mudarabah share has been set then the figure ($32517) denotes the
optimal dividend payment under the given mudarabah contract, i.e. 40
per cent of the pre-dividend income being paid out as dividends.
Corresponding to this level of dividend payments the retained earning of
$47557 is also optimal. The dividend-retained earning configuration in
the Islamic firm is therefore unique for a given mudarabah contract.
Now let us observe line (8) of the Income Statement II. The dividend
payment ratio is variant. In order to compete with a similar firm in the
Islamic economy, and thereby attract external capital for financing its
investment and production, the firm would try to maximise dividend
payments. The limiting case for the dividend payments would be that
equal to the Islamic case ($32517). However, in such a case the dividend
payment turns out to be about 42 per cent of the net income. This is a
rather high ratio for the firm in a conventional economy. The usual ratio
centres around 30 per cent to 35 per cent. The dividend payments at 35
per cent is lower-$27300. But in this case the retained earning has
increased to $50700, i.e. by $6 154, the same amount by which dividends
have decreased.
There is, therefore, a trade-off between dividends and retained
earnings in a conventional economy. For any given combination of
dividends and retained earnings the sale revenue and net operating
income for the firm remain unchanged. The shift to the objective of
maximising retained earning implies that the firm moves on for a greater
use of internal sources of financing its production. This would serve the
purpose provided much of the common stock dividends was reinvested.
But in the case where the income-tax rate is low and the same for the firm
in both the Islamic and the conventional economies (2.5 per cent) there
would be high incentive for the dividends to be cashed by the
stockholders. Therefore, ceteris paribus, a lower level of the dividend
payments (while increasing retained earning) would mean a lower value
of the firm's common stock. This is contrary to the firm's objective in a
conventional economy, i.e. to maximise the value of the common stocks.
Therefore, given a trade-off between dividends and retained earnings,
the firm must look for maximising of dividends. This in turn is a
48 Microeconomics
reflection of the fact that higher dividends are being generated by the
firm's stock of real assets and new investments, for which the firm has to
take recourse to stock financing and equities. On the other hand, an
increased mobilisation of retained earnings for internal financing of
investments and production by the firm today will reduce the level of
stock financing and equities tomorrow. This reduction could mean a
lower demand for the firm's common stocks, in which case the value of
the common stocks is not maximised. This is a contradiction to the
established objective of the firm. These results bring us to recognise the
congruence of the option of post-dividend income taxation with
increasing dividend payments, with the characteristic of the income
statement of the firm X in an Islamic economy.
A DIAGRAMMATIC EXPLANATION OF THE OPTIMAL

DIVIDEND-RETAINED EARNINGS TRADE-OFF FOR THE
FIRM
The implications of the trade-off between dividends and retained

earnings in the firm's income statement and the balance-sheet can be
explained with the help of Figure 4.1. Diagram (a) corresponds to the
characteristics of the firm's income statement. Diagram (b) corresponds
to the characteristics of the firm's balance-sheet. Diagram (c) cor-
responds to the alternative possibility of increasing the mobilisation of
retained earnings in investment.
The sets OPP', OTT', OQQ', etc., comprise the opportunities available
to the firm for maximising the net value of the firm by the best trade-off
between dividends (D) and retained earnings (E) over time. The optimal
trade-offs between these two variables are denoted by the points like, AI,
A ~ , A 2, etc., over time. Along the surface of any given opportunity set the
sales revenue and the net operating income remain unchanged.
Corresponding to the optimal trade-off point A 1 at a given point of
time, there is a point B 1 on the surface of the investment opportunities
set, OMM', giving the optimal level of real investment (J 1) and other
investment (J 1) at the present time. Likewise, the point A2 corresponds
to the point B2 at a subsequent point of time. The correspondence
between A2 and B2 implies that higher levels of dividends (D 2) over time
are made possible by higher levels of investments (J 2). The level of
increase in the retained earnings is irrelevant here because of the firm's
objective to maximise the value of common stocks.
Diagram (c) is the reverse form of Diagram (b). Now the fj.rm is seen to
(b) (a)
D
Q
N
/ 1 1 - - - -......
N'
~--~---u--~~-J
o O~----~E--~~~--~-E
1
I
I
J I
K I
(e)
FIGURE 4.1 Implications of the optimal dividend-retained earning trade-off
mobilise its retained earnings in new investments. Points like C 1, C; , C 2

are optimal investment levels mobilised by the retained earnings E 1 , El
and E 2 , respectively, over time. It is noted, however, that although
12 > I; > 11, corresponding to E2 > E; > E 1 , there could be the
possibility like the point A; on the surface of TT', where the dividends
(D 1) remain unchanged. Therefore, increased mobilisation of retained
earnings in investments does not necessarily increase dividends over
time. Consequently the value of common stocks may not necessarily be
maximised.
We thereby reach the same conclusion as that found in our quantitat-
ive investigation of the firm's financial statements. That is, the firm must
50 Microeconomics
emphasise the objective of maximising dividend payments so as to

optimise the value of its common stocks. This point also establishes the
importance of the dividend characteristics and the method of post-
dividend income taxation of the firm in an Islamic economy.
SUMMARY
The interrelationship between the income statement and the balance-

sheet of a firm in the Islamic economy is now established. Higher
increases in dividends on mudarabah shares give incentive to mudarabah
stockholders. This mobilises increasing amounts of money capital of the
firm to finance investment in real capital, thereby increasing the long-
term liabilities on the liability side of the balance-sheet. The mobilisation
of these liabilities to finance real assets is shown on the fixed-asset
component, particularly on the asset side of the balance-sheet. This menu
of real capital formation by a firm in the Islamic economy along with the
degree of risk diversification effected through mudarabah shares are the
pillars of success in maximising the social value of the firm in the Islamic
economy, as indicated by the optimisation of its net worth.
5 The Role of Zakah,
the Islamic Quasi
Wealth Tax,
in Resource Allocation *
INTRODUcnON
The main purpose of this chapter is to place the role of zakah in the
context of resource allocation in perfect and imperfect market settings.
The chapter is divided into three parts. In the first part the theoretical
aspects of zakah induced resource allocation is discussed. In the second
part the role of zakah in resource allocation is further studied with the
help of a Social Service Model in the Islamic economy. In the third part
the results of zakah-induced resource allocation are further empirically
studied in a cost-benefit model with Saudi Arabian incomes data.
Before we go on to the body of the chapter let us define two basic
terms that will be used later on. The first term is zakah, which in the
Quranic terminology means a compulsory payment by the wealthy to
the economically under-privileged. This does not, however, mean that
zakah is charity. On the contrary, it constitutes the principal revenue of
the Islamic state to be spent on specific groups of people and activity. 1
At the same time zakah cannot be treated as a tax in the modern sense of
the term, because it transcends sheer economic considerations. Payment
of zakah is obligatory on all Muslims who are eligible to pay it. The
second term to be defined is nisab, which is a term meaning the minimum
level of income below which personal income is not zakatable. 2
• This chapter comprises a combination of three papers of the author: 'The Role of az-
Zakah in Resource Allocation', in Some Aspects ofthe Economics ofZakah, ed. R. Zaman
(Indianapolis, Ind.: American Trust Publication, Mar. 1980); 'A Social Service Model in
the I-Economy', Proceedings of the Seventh Annual Conference (Association of Muslim
Social Scientists, 1979); 'An Application of the Islamic Social Welfare Function to Cost-
Benefit Analysis', chap. iv of M. A. Choudhury, An Islamic Social Welfare Function
(Indianapolis, Ind.: American Trust Publication, Jan. 1983).
51
52 Microeconomics
ZAKAH AND RESOURCE ALLOCATION IN PERFECT AND

IMPERFECT COMPETITION
Resource allocation must be studied in relation to perfect and imperfect

competition. Perfect competition is characterised by an ideal state of
market mechanism of exchange of goods and services in which each
agent has full information of the market; there is no control on prices
and quantities by any individual or agent; there is no presence of
external economies and diseconomies in either production or consump-
tion. In the presence of perfect competition the market mechanism is in a
state of equilibrium in the sense that the allocation of goods and services
in the economy is such that it is not possible within that allocation to
improve the satisfaction of a given consumer without making the other
exchanging consumer worse off. From the consumers' point of view,
households in a perfectly competitive market are endowed with initial
resources and they choose their consumption levels to maximise utility
at a given set of prices. The obverse side of the coin is the production
point of view, in which firms produce goods and services for consump-
tion by households such that aggregate production plus initial resources
equals aggregate consumption. 3
In Islamic economics the idea of perfect competition as defined above
is an acceptable concept. It was in fact implied by early Islamic social
researchers long before Adam Smith introduced his economics of laissez
faire. Ibn Khaldun, for example, wrote on the concept of division of
labour in the following words long before Adam Smith: Human labour
is necessary for every profit and capital accumulation. . . . Without
human labour no gain will be obtained, and there will be no useful
result .... It should be further known that the capital a person earns
and acquires, if resulting from a craft, is the value realised from his
labour.... If the profit results from something other than a craft, the
value of the resulting profit and acquired capital must also include the
value of the labour by which it was obtained. 4 The division of labour
referred to here was the basis of marginal productivity theory and
technological change in classical economics. The marginal productivity
oflabour was the real wage for labour, which in tum was created by the
division of labour in any production process. 5 It is therefore evident
from the history of Islamic social science that the concept of perfect
competition, as explained above, is acceptable by Islamic economics. It
is logical therefore, to find zakah as a powerful instrument of resource
allocation in a perfectly competitive setting.
Perfect competition is, however, not a real-world situation. It is only
Role of Zakah, the Islamic Quasi Wealth Tax 53
to be considered as a desired norm according to which government and

market should allocate their economic resources. The departure from
perfect competition is caused by such factors as the presence of external
economies and diseconomies, lack of full knowledge on the part of
buyers and sellers, control of prices and quantities by a few agents, all of
which cause a failure of the market in allocating its resources in an
efficient way. In order to reduce the imperfections and bring about a
mode of resource allocation nearer to the condition of perfect com-
petition, the state continuously looks for appropriate ways and means.
In the Islamic economy imperfections can arise due to the presence of
externalities and non-market factors. For example, the spill-over effect
of Islamic public education on the socioeconomic environment is very
strong. This is mainly due to the presence of the strong ideological
element in such an education system. The primary purpose of Islamic
education is to imbue students with their religion and ideology. They
should be taught the meaning and purpose oflife, man's position in the
world, the doctrines of tawheed (unity of God), risalah (prophethood),
akhira (life hereafter) and their bearing upon individual and social life,
the Islamic values of morality, the nature and content ofIslamic culture,
and the obligations and mission of a Muslim. 6 All these incur social
costs and social benefits which may not be of a purely economic nature.
In the Islamic economic system market distortions, due to monopolistic
competition or control of resource by the state in a way that denies free
enterprise, are not relevant because such an economic system would not
allow monopoly or a socialistic control of resources. In any case, in one
form or the other the idea of perfect and imperfect competition in
resource allocation is recognised by Islamic economics. Zakah as a
powerful tool of resource allocation in an Islamic economic system
must, therefore, take account of these two situations.
The objective of reducing Pareto inefficiencies in an imperfect
competition is to bring about an income distribution that is both
efficient and equitable. 7 The fact is that if we were to accept a Pareto-
optimal situation, it would mean that each individual must be rewarded
according to his marginal productivity that depends on better educa-
tion, family background, etc. - factors which may not be available to all
sections of the population. The state must, therefore, intervene to alter
the absolute or relative economic positions of the underprivileged
groups of people. Income distribution, therefore, involves allocative
efficiency. The term 'allocative efficiency' deserves some attention here.
The efficiency of resource allocation associated with each mode of
income distribution is referred to as allocative efficiency. It is to be noted
54 Microeconomics
that in the presence of state intervention to alter an existing mode of

income distribution, there is no uniquely determined efficient allocation
of resources. Rather, there is an efficient allocation corresponding to
each initial distribution of income. The reason for this is that income
distribution affects consumers' demand pattern and the supply patterns
of resource owners, which in tum determines the production pattern,
and the production pattern together with consumption pattern maxi-
mises the social welfare function which is not unique. Hence, a mode of
resource allocation efficient with respect to one mode of income
distribution may be quite inefficient if the mode of income distribution is
altered.
Allocative efficiency involves only net marginal effects, and therefore
welfare gains from increased allocative efficiency is quite small. Now in
order to ensure a higher level of efficiency in resource allocation there
must be the existence of an initial undefined type of efficiency. This
initial undefined type of efficiency is referred to in the literature as X-
efficiency. 8 Empirical evidence shows that X-efficiency is a significant
source of increased output. It is determined by: (l) intra-plant motiv-
ational efficiency, (2) external motivational efficiency, and (3) non-
market input efficiency.
Since there are a number of scenarios of efficient allocation of
resources corresponding to different modes of income distribution, so
the zakah induced resource allocation can be considered as one of such
efficient modes of resource allocation. The question that remains to be
examined is how in the presence of zakah, resource allocation is more
efficient and more equitable than other alternatives. To look at this
point we shall tum to allocative and X-efficiency again. We have said
that allocative efficiency brings only marginal gains to social welfare.
Therefore, to bring about a substantial increase in allocative efficiency
one must increase X-efficiency, one of whose components is external
motivational and non-market efficiency. In the Islamic social system the
external motivational and non-market efficiency factor is very strong.
Zakah, while being an obligatory tax on all well-to-do Muslims, is also
considered as one of the five basic pillars of Islam, and next to prayer
(safat) it is the most important religious duty enjoined on Muslims.
Hence, zakah is a socio-religious instrument of income distribution and
resource allocation not to be found in the theory of public finance.
Apart from zakah the principle of shirakah (partnership) is also used
in Islamic economics to encourage partnership in work between labour
and capital. 9 Through such a partnership, intra-plant motivational
efficiency can increase and a choice of new techniques can come about,
which in tum increases X-efficiency.
Role ofZakah. the Islamic Quasi Wealth Tax 55
Speaking further on the allocational efficiency of zakah, it can be

shown analytically that zakah is associated with an income multiplier
effect. 10 This is explained via the relationship between zakah rate and
income level through changes in the investment level. Since zakah is
imposed on idle assets only, which otherwise could have been put to
productive use, so economic rationality on the part of the investor would
motivate him to deplete his idle stock of capital and thereby make room
for investment flows. Increased investment will thereby cause increased
income through the multiplier effect. Therefore the presence of zakah
will cause holders of idle capital stocks to put them into productive use.
Investment flow will cause income to increase through the multiplier
effect. Thus, the multiplier is a positive function of zakah. Note now that
the an-nisab level will-continuously shift upwards subsequent to higher
standards ofliving brought about through the positive effect of zakah on
investment and income.
Next let us examine the role of zakah in an equitable distribution of
income. In existing tax systems of different countries equity is thought to
be achieved when individuals and families pay taxes that are a constant
proportion of their discretionary power. 11 Discretionary power is
defined as the power of the individual to command goods and services
for personal use, minus the amount needed to maintain a given standard
of living. This is, however, only one aspect of the concept of equity
principle used by the government sector. The other instrument of equity
is redistribution of income, which is used to achieve a reduction in
income inequality. Therefore, taxation and the model of expenditure
both are necessary to improve social equity. Zakah recognises both these
principles, but its mode of collection, expenditure and philosophy are
different from those of existing taxation systems.
Speaking first on the collection of zakah it is to be noted that the
following assets are zakatable:
1. Income above the an-nisab minimum. An-nisab is the minimum

level of personal income that exempts an individual from paying zakah.
It is determined by the weighted sum of an individual's labour income
and value of other-money income at a given time.
2. Productive assets left idle for a year. Under this category all items
of wealth which do not normally depreciate over time are included.
Thus, zakah is different from a pure income tax, because it is also a tax
on wealth, not exempted by an-nisab at a given point of time. Wealth
taxation, although present in current taxation, is subject to several types
of exemptions that the individual can work out through a diversification
of investment.
56 Microeconomics
3. Profits and windfalls from economic activity. Profits and windfalls

which are not reinvested within a year become zakatable. The relation-
ship between the zakah rate and production incentive explained before
applies here too.
4. Inheritance. This is considered as an item of wealth and is,
therefore, zakatable once and for all.
So much for the categories of zakatable assets. Next, let us see on
whom zakah could be spent. Eight categories of zakah expenditure have
been enumerated in the Quran (Sura 9 verse 60).
1. The poor and the needy. Zakah is used here as income support and
supplementation, but under the needs test only. It need not satisfy the
income test. For example, in the case of the voluntary unemployed,
zakah cannot be payed on the basis of the income test.
2. The employee of the zakah management. Zakah, the principal
source of revenue for the Islamic state, is collected and distributed by an
established state department. The wages and salaries of those who
manage the zakah fund would be paid out of it.
3. Strengthen the financial position of new Muslims. Here zakah is
spent to provide services to new Muslims in absorbing them as a
progressive and resourceful economic segment of the labour force.
4. For the liberation of slavery.
5. For helping to payoff debts made for legitimate reasons. It seems
plausible that, apart from helping individuals and firms in need of funds,
the zakah fund could also be spent by the state as an alternative to debt
financing. The concept of a contingency fund to evade debt financing
and still meet the needs of the government for expenditure in goods and
services is not remote in many existing national budgets. 12 If the zakah
fund is to be treated also as a contingency fund of this type, the
borrowing by the government will be internal, and, therefore, increased
borrowing by the government from this fund will neither increase
inflation nor the income-tax rate. On the other hand a total financing of
a deficit budget by external borrowing would cause inflation to rise, and
the state would have to step up the income-tax rate as one of the policies
to curb the inflation on the face of increased budgetary expenditure.
6. Islamic missionary activity. Although missionary activity is the
predominant note here, there is no reason why part of the zakah fund
cannot be used to finance education and research in the Islamic setting.
7. The wayfarer. The zakah fund can be used on a wayfarer to
ameliorate his emergency needs. In an organised Islamic state we can
think of the zakah fund being spent partly on the necessaries -like
medicare, food and lodging-for the wayfarer, etc.
These categories of zakah expenditure can be further extended by

analogy. For example:
a. Categories 1,3,5, and 6 can be used for training of the employable,
and for family welfare;
b. Categories 1,3, and 5 can be used for the rehabilitation of the aged,
income support of the unemployed, income support in the case of
economic losses, and so on.
Having seen the strong motivational and egalitarian characteristic of
zakah in resource allocation, which brings about both allocative as well
as a significant increase in X-efficiency, it only needs to be shown that
zakah, unlike income-tax incidence on income, brings about a higher
participation rate for the labour force. This effect of zakah can be
established by looking at the relationship among zakah, increased
investment, and increased income. Increased investment and income
stimulates employment and higher economic expectation which in turn
reduces the discouraged worker margin, thereby causing an increase in
labour force participation. 13 Hence, zakah proves to be a powerful
instrument not merely for an equitable mode of income distribution, but
also an efficient mode of resource allocation, quite contrary to the
existing taxation systems.
The non-distributional and disincentive effects of resource allocation
in modern states are many. For example, the disincentive effects of the
minimum wage on labour force participation and employment levels are
well known. 14 One is also aware of the disincentive for labour force
participation by welfare recipients, caused by what is known as the
welfare trap, whereby individuals do not want to escape from welfare,
because social assistance as it exists today provides them with financial
and non-financial benefits to the extent of keeping them out of the
labour force activity, thereby politically controlling the recorded
unemployment rate. 1 S
The non-distributional aspect of existing welfare programmes can be
seen from the failure of these programmes to extend benefits to all the
non-working poor. There is also economic and social inequity linked up
with this non-distributional aspect of social assistance. For example, a
low-paid working person may earn less than a non-working person who
gets more through welfare payments. Furthermore, the low-paid
working person pays taxes on a part of his income, unemployment
insurance contribution, etc., while he may also be denied the various
benefits in kind, like day care, free health coverage, legal aid, etc. All
these add up to the inefficiency of distribution and income disparity
58 Microeconomics
between the working poor and the non-inequitable, and inefficient

modes of income redistribution, and resource allocation, zakah thus
emerges as a powerful tool of fiscal policy. Hence, instituting zakah as a
national policy instrument deserves particular attention by Islamic
governments.
The various categories of collection and disbursement of the 'zakah'
fund as given in the Quran, can be extended by analogy. It would then
comprise expenditure in training for the unemployed; family welfare;
rehabilitation of the aged; income support of the unemployed; income
support in case of economic losses. These components of possible
expenditure of the zakah fund can be considered in a social welfare
model in the Islamic economy. The term 'social service' used here
includes services such as education, family welfare, as well as social
security and other types of welfare maintenance of the needy.
ASSUMPTIONS
In order to establish the social service accounting model we shall make

the following assumptions.
1. The existence of an Islamic state, where an Islamic economic system
functions in its required form. The I-economy is characterised by the
absence of interest on loanable and investible funds. The financial system
in the I-economy is characterised by the existence of the zakah fund.
2. In the I-economy collective individual preferences are uniquely
expressed in the social welfare function of the Islamic State. Therefore, in
the I-economy the state becomes an ideal representation of collective
individual preferences.
3. Since the state becomes an ideal representation of individual
preferences so social service becomes a pure public good, and all indirect
costs in social services are financed by public authority.
The three components of social service in our model are education and
retraining, family welfare and social insurance. These three components
of social service are all financed by the state, and the state recoups the
expenditure through income-taxes. In the I-economy the social service
income-tax rate is reduced by the zakah rate
COMPONENTS OF COST TO THE STATE IN SOCIAL SERVICE

FINANCING
The following components of cost of social service financing constitute

the cost side of our accounting model:
(1) a proportion of the total cost of bringing up an individual from birth
to the age of say fifteen years, which may be taken as the dependency
period. The value of this cost is determined for an individual of age x in
year to when he leaves the educational system after a specific educational
achievement. Let this component of social service cost be denoted by c~ 5
in per capita terms
(2) A proportion of the total cost of educating an individual over a
period of time till when he leaves the educational system at age x in year
to·
(3) The cost of social insurance paid to the educated unemployed over a
period of time. The value of this social insurance payment is determined
at time to, but the actual payment of the social insurance is made from
after a year of leaving the educational system. This period of a year is
allowed as the waiting period for one to be eligible for social insurance on
the basis of an individual's contributions through his earnings.
Although the model is formalised for educated manpower, it is equally
applicable to the unskilled manpower. Only the first part is looked at in
this chapter. It is easy to simply extended the model to unskilled
manpower.
COMPONENTS OF BENEFIT TO THE STATE FROM SOCIAL

SERVICE
In the I -economy increases in per capita earnings of educated manpower

depend on merit and aptitude, and increasing per capita earnings of
educated manpower push up the per capita earnings of the entire
population active in the labour force. Per capita income, on the other
hand, is a positive function of age (experience). Through the spill-over
effect of educational earnings the earnings of the total population
becomes a positive function of ability which in tum is a positive function
of age (experience). Therefore, a proportion of the earnings of the active
population of the same age as the educated manpower under considera-
tion is taxed away to cover a part of the total cost in social service
expenditure at a given point of time t o.16 The total benefit in the
60 Microeconomics
accounting social service model is therefore taken as the total output of

the active population of the same age as the educated manpower, that is
taxed away to recoup the cost of social service expenditure. In the 1-
economy the age specific per cpaita income is really the above-an-Nisab
income, and is therefore zakatable.
EXPRESSIONS FOR COST AND BENEFIT COMPONENTS: THE

SOCIAL SERVICE MODEL
Let c1 s denote the value of per capita cost at time to in bringing up an

individual from birth to age of fifteen years (the dependancy period) for
an individual who is of age x when he leaves the educational system.
Px (10) denotes the total population in the labour force of age x
in year to.
Thus, c1 s p%(to) denotes the total cost of bringing up all individuals
over the dependancy age for those of age x at time to.
Only a proportion of c~ s P% (to), T, is recouped in year to. Therefore,
the applicable cost component on family welfare is T~c1s p%(to).
Let ifo denote the value of per capita expenditure at time to in educating
an individual over a period of time to the age of x years, when he leaves
the educational system with a given level of education.
As in the case of family welfare, the applicable cost component of
education at time to is given by T~i~OP% (to).
Finally, we have the social insurance cost component of social service.
An individual leaving the educational system at time to could remain
unemployed or become unemployed at any point of time after leaving the
educational system. For planning purposes it is only relevant to consider
the total expected government social insurance payment at the end of
each year. Consideration for this expenditure must, however, be given by
the government at the beginning of each year. The value of these
payments is taken at the period of time to when the individual of age x
leaves the educational system.
Let bx + t denote the unemployment rate at time t for individuals of age
x+t.
1% +t (t + to) denote the labour force (educated manpower in our case) of
agex+t at time t+to.
The social insurance contingency formula is given by17
L b%+tl%+t(t+tO)vt-
N
AN= M' 1,
t= 1
Role ofZakah, the Islamic Quasi Wealth Tax 61
where M' denotes the actual unemployment insurance payment, v

denotes a suitable discount factor.
The total cost on social service is now given by,
N
1'x(cfs+1,';)Px(to)-M'L bx+tlx+t(t+to)v'-l.
t ~ 1
On the benefit side of the model we have a proportion, O(X, which is the
income-tax rate on per capita income Yx (to), taxed away to cover the cost
of social security applicable at time to. The total benefit contributed by
the active population of age x at time to is now given by O(xyx (to)Px (to).
The model is now established by equating cost to the benefit of social
services:
N (1)
T~hxPx + M' L bx+tlx+t(t + to)vt - 1 = O(xYx (to)PAto)
1= 1
where hx = Cl"5 + 110 denotes the total per capita cost in human capital
investment part of the social service expenditure.
Write IX+I (t + to) = IAto)(1 - (t - to)nx+/),
where nx + 1 denotes the attrition rate between ages x at time to and x + tat
time t + to.
Our social service model can now be written in the form,
(2)
where Tx = T~/O(x
Px = lAto)/PAt o), is the manpower/population ratio for educated

manpower.
Mx = M'b x, assuming that bX+1 = bx·
We shall now use (2) to study the sensitivity of O(x on the income level
Yx, and on the manpower/population ratio, Px·
EFFECT OF ZAKAH RATE ON PER CAPITA INCOME AND

LABOUR PARTICIPATION
Let us first examine how a partial variation in O(x can affect YX.
iJyxjOax = - (Yx/O(x)
Now, put O(x = Z + O(~
where, z denotes the zakah rate, z ~ 2.5 per cent.
O(~ denotes the income-tax rate which is essentially independent of z,
and may also be zero in the I-economy. Earlier in this chapter we have
62 Microeconomics
outlined the difference in the nature of the income-tax rate and the z-rate.
The main difference between the zakah rate and the income tax rate is
based on the fact that while the former is associated with an income
multiplier effect, the latter has an income reduction effect. This is
explained via the relationships between the zakah rate and income level
through changes in the investment level. Since zakah is imposed on idle
assets only, which can be put to productive use, so economic rationality
will call for a depletion of all idle stocks to make room for investment
flows. Increased investment will thereby cause increasing income through
the multiplier effect which is calculated at the end of the fiscal year (zakah
year). Therefore, if the zakah rate increases it will cause holders of idle
capital to put them into productive use. Investment flow will cause
income to increase through the multiplier effect. Hence, the multiplier is a
positve function of the zakah rate, unlike the case of a negative
relationship between the multiplier and the income-tax rate. With this
mechanism in operation, the an-Nisab line will also shift upwards
subsequent to higher standards of living brought about through the
positive effect of zakah rate in investment and earnings. This is the
economic reasoning of the above result, which shows that if we had only
IX~ in financing the social service expenditure, the effect on Yx will be more
distinctive than if we had z added to or replace (X~. If we have z added to (X~,
then the actual income-tax rate is reduced by the zakah rate. During the
time of Prophet Muhammad all taxes were covered by the zakah fund. It
is quite possible that in modern times the magnitude of (X~ will be close to
zero in the presence of the zakah rate, as in the case of Saudi Arabia.
Now let us turn to the second part of the issue that we wished to
analyse: the effect of the zakah rate on labour force participation. In
equation (2) let
(3)
I' is estimated by regressing Yx on Mx in equation (2). If I' is to remain
fairly stable over time, then it can be shown that
Pxla. x = A (constant),
i.e. Ixl Px = AlXx
where, IXx = Z + (X~, z ~ 2.5 per cent, lXx' ~ O.
This relationship again implies, that since the zakah rate and the
multiplier are positively related, therefore an increase in the zakah
rate brings about increased income through increased investment
flow, which in turn creates higher labour-force participation rate.
Therefore, in every case we find that the presence of the zakah rate in
Role ofZakah. the Islamic Quasi Wealth Tax 63
social service financing has an incentive effect on per capita income, and
thereby on social service financing.
The investment, income and zakah relationship can be represented by a
diagram: Figure 5.1 denotes the relationship among the investment
flow I, thezakah rateZ, and the social welfare function U(J, Z). U(I, Z)is
a positive functional of the social welfare function in personal income,
obtained as returns from increased investment J, and the interaction
between J and Z. Thus U (J, Z) is itself a social welfare function, being a
monotonically increasing function of a utility function. The line PP'
denotes a suboptimal allocation of resources, and the suboptimal
relationship between J and Z is represented by point A' on the line PP'.
The existence of idle resources brings about an increase in the zakah rate
from A to B. If this shift is to be optimal, point A' must move to point B'
where the social indifference curve SS' just touches the social welfare
function, U (J, Z). B' is the point of optimal relationship between J and Z,
and the line PP' shifts to QQ'.
Figure 5.2 denotes the relationship between personal income Y and
investment J. Corresponding to the suboptimal allocation of resources at
point A', the relationship between Yand J is represented by the point A",
on the line, RR'. As A' shifts to B', A" shifts to B", giving the optimal
relationship between Yand J.
The Social Service Model developed above and the results arrived at
can be further extended with the help of a cost-benefit model in the
Islamic economy. We now tum to a development of one such model and
its analysis.
ADAPTATION OF THE ISLAMIC COST-BENEFIT MODEL FOR

EMPIRICAL WORK
We shall now investigate how the general form of the cost-benefit model
given by the following expression may be adapted for empirical work:
N
W= L R,/(1 + r)', (4)
,= 1
where R, '" R i " i = 1, 2, ... , m for individuals receiving the returns
= L
i= 1
R i" t = 1, 2, ... , n periods of time. R, is the total return overindividuals,
time and monetary as well as non:'monetary returns.
64
U(I,Z)
s'
Q'
FIGURE 5.1 Relationship among zakah rate, investment and income in the
I-economy
R'
H'~-----------+----~~
B"
H"I--------~
K K'
FIGURE 5.2
'I being the rate of return to society on pure economic returns;'2 being
the rate of return on the pure non-economic returns in an Islamic state.
Let us take an example of an Islamic government that is using zakah
fund for some specific type oftraining programme of the needy segment
of the labour force.
Let {Zo, Z ..... ,Zn} denote a sequence of zakah fund expenditure
on the training programme, over n l periods of time, and on an
individual. Let {YO'YI, ... ,yn} denote a sequence ofindividual earnings
resulting from the training programme over n2 periods of time, n2 > nl'
It is therefore being assumed that the training programme is some sort of
on-the-job training, so that a trainee is able to earn wages even when he is
in training. Let {S"S2, ... ,Sn.} denote a sequence of savings of an
individual over n2 periods of time, which exceed the nisab level, which is
the minimum level of savings to qualify one for receiving zakah. It is
assumed that there are no savings subject to zakah at the initial point of
time of the training programme.
Let {eO,el, ... ,en.} denote a sequence of employment rates over n2
periods of time. Therefore, {eoYo,elYl,'" ,en.yn.} denote a sequence
of individual expected earnings over n2 periods of time. z = 2.5 per cent
of savings, denotes the rate of zakah on savings.
The cost side of the cost-benefit model would be the present value of
the zakah fund spent on the training programme for an individual, i.e.
", Z
Cost = Zo +
,=L1 (1 +'2
'y (5)
Note that a rate of return, '2, is used for discounting the zakah-stream,
indicating that the zakah fund is established as an ibadah in sector 2 of
the Islamic social goods system, through individual Islamic value
formation.
The benefit side of the model is given as the present values of
individual expected earnings and the zakah generated by the savings of a
trainee, reSUlting from increased productivity through the training
programme.
n. e, y, n. Z S, _1
Benefit = eoYo + L (1 )' + ,=2
,=1 +'1
L (1 +'2 ( (6)
Note again that a rate of return '1

is used to discount the pure
economic returns, those earnings resulting from increased productivity
66 Microeconomics
of the trainee. The economic returns are seen as if generated in sector 1 of

the general equilibrium social goods system in an Islamic economy.
However, a rate r2 is used to discount the 'induced' flow of zakah,
resulting from increased savings of the trainees through the training
program. Following the argument given above, r2 is the appropriate
discounting rate. Note further that in expression (6) although we are
evaluating the benefit of the state training programme to an individual,
the last term appears with a positive sign. This indicates that the
investment and consumption returns are additive in an Islamic social
goods system.
However, the newly accrued flow of zakah would find itself in the
consolidated zakah fund, and would therefore appear on the 'cost' side,
too. Therefore, the last term in expression (6) will drop out and we will
have for benefit,
The present value of net returns from the training programme is now
given by
(7)
By putting pv = 0 we have the strictly cost-benefit model. Model (7) is a

practical analogue of model (4) for a simple training programme.
Using the present value expression (7), we can readily derive an
expression for estimating the welfare effect of zakah, i.e. the multiplier
effect of zakah on income from training. To establish this, consider the
following:
8PV 1
--=-
8Z t (1 + r 2 )t
8PV et
--= t.
oYt (1 +rd
Since the present value result is only a transformed function of the
social welfare function they both provide welfare levels in an Islamic
community, in this case the welfare of trainees in a training programme.
For deriving optimal welfare from this programme, we would have
-dYt 1(1 +
dZ, = -;, l+r2
r1)t
.
(8)
It has been shown earlier that the labour-force participation rate is

proportionately related to zakah. Hence, under certain simplifying
assumptions we can take the employment rate e" to be proportionately
related to zakah, so that e, = hZ,. h > 0 is the constant of proportio-
nality. On substituting this expression in expression (8) and integrating,
we obtain
A
Y, =C- Z2' t = 1,2, ... ,n2, (9)
1
C > 0, is a suitable constant,
1 -
A = (-
1 +r2
+rl)' > 0, for t = 1,2, ... , n2. (10)
Expression (9) gives the welfare effect of zakah, through its multiplier
effect on earnings from the training programme. Simultaneously, the
employment rate is higher, too.
EMPIRICAL ESTIMATION OF A COST-BENEFIT MODEL FOR

A ZAKAH-FUNDED TRAINING PROGRAMME AND
RELATED WELFARE RELATIONS IN AN ISLAMIC ECONOMY
Let us first estimate the cost-benefit model given by (9) from data on
individual estimated earnings and zakah for Saudi Arabia. For this we
must first estimate the rates r 1 and r2.
TABLE 5.1 Estimates ofper capita income and zakahfor Saudi Arabia at market
prices. 1960-75
(U.S. dollars)
Saving
(assuming Zakah
15% of Consumption (2.5% of
Year Income income) (col. 2-col. 3) col. 3)
1970 495 74.25 420.75 1.86

1974 2478 371.70 2106.30 9.29
1975 3538 530.70 3007.30 13.27
SOURCE United Nations Statistical Year Book (New York: United Nations, 1978) table
194: Estimates of total and per capita national income and national disposable income (per
capita income in market prices).
68 Microeconomics
For a balanced growth of a two-sector general equilibrium social

goods system, where one sector is endowed with purely economic goods
and the other sector is endowed with purely 'non-economic' goods, we
shall take the rates, r 1 and r 2, respectively in these sectors, to be one-half.
This also avoids the difficulty of estimating the purely economic and
'non-economic' returns in the absence of adequate data. We shall also
assume a rate of return of 3 per cent on savings, the dividend rate
presently being offered by chartered banks in Saudi Arabia. Now in
order to obtain a 10 per cent return on economic returns from
training - a reasonable rate for investment in human capital- we require
a rate on Islamic social returns of 17 per cent *, i.e.
r 2 = 2 x 0.10-0.03 = 0.17, r 1 = 0.10.
This high estimate of r 2 indicates the importance of purely non-
economic returns on the level of social welfare in an Islamic community.
We can now evaluate the present value of net benefits of the training
programme over the period 1970-75 for Saudi Arabia. For this we first
distribute the income and zakah linearly over the period, 1970-75.
TABLE 5.2 Linear distribution of per capita

income and zakah for Saudi Arabia, 1970-5
(U.S. dollars)
Year Income Zakah
1970 495 1.86

1971 991 3.72
1972 1487 5.58
1973 1982 7.44
1974 2478 9.29
1975 3538 13.27
SOURCE As for Table 5.1.
Assuming that the training programme lasted for four years and an
individual continued on in the job with the training acquired until 1975,
and that average earnings were comparable with per capita income as
stated, we obtain the following schedules of present values of earnings
* Blaug suggests a social discount rate of about 13 per cent for evaluating investment in
education in India. (M. Blaug, An Introduction to the Economics of Education
Harmondsworth, Middlesex, 1970).
and zakah, and the net present value:

1975 y.
,= L (103)1'970' =
1970 .
$10018
1973 Z
,= L (117)1~70'
1970 .
= $13.76.
Therefore, PV = $10004.
Next we shall estimate expression (9), which gives the welfare effect of
zakah on training income. For this we must first obtain an estimate of the
coefficient 'A' in expression (9).
TABLE 5.3 Estimate of the coefficient 'A' in the

income-zakah relation for Saudi Arabia, 1970-3
Year Value of'A'
1970 1
1971 0.88
1972 0.78
1973 0.68
Average (estimate) 0.835
SOURCE Usingestimatesofr 1 = 0.10,r = 0.17 in expres-

sion (10). for t = 0, 1, 2, 3.
An estimate of the coefficient 'c' in expression (9) is obtained by

allowing this curve to pass through the mean values of y and 1/Z2. In this
way we finally obtain the estimated income-zakah multiplier relation.
y = 1487 _ 0.835
Z2
for different values of y and Z2. The expression clearly shows the welfare
effect on y is such that as zakah increases, the income from the training
programme increases. These increases occur through the labour produc-
tivity augmentation by zakah.
A more complete picture of the welfare effect of zakah must include its
relationship with the employment rate. What then results is an income-
employment-zakah relationship:
y = C- ;2' denoting the income-zakah relationship, and

70 Microeconomics
e=hZ,
denoting the employment-zakah relationship. Unfortunately, due to the
unavailability of data, the latter relationship could not be estimated.
However, we can still demonstrate the interrelationship of the above two
results in Figure 5.3.
cr-----------------------~=-~~-----
Z31 z
e I
I
I-
I
I
•
FIGURE 5.3
The constant 'c' (C = 1486) represents a maximum target income that

could result from the zakah-funded training programme. It is a ceiling
which is reached gradually, with increasing amounts of zakah progress-
ively augmenting the earnings through increases in the labour produc-
tivity of trainees. This is shown in the upper part of Figure 5.3.
Increasing productivity of trainees also increases their. chances of
employment. Hence, each zakah level, through increased trainee produc-
tivity and increased earnings is also related to improved employment
rates. The employment rates for various levels of zakah are primarily
distributed in a cluster diagram. We obtain the best fit by the regression

line as shown. This is shown in the lower part of Figure 5.3.
SUMMARY
In this chapter we have first introduced the Islamic idea of resource

allocation in a comparative economic perspective, in order to bring out
the importance of the X -efficiency aspects of such modes of resource
allocation in welfare models. We have then developed a general form of a
cost-benefit model for an empirical analysis of the costs and benefits of a
zakah-financed training programme. The empirical work done with
Saudi Arabian incomes data is unfortunately crude due to paucity. The
results are none the less suggestive. In the empirical analysis we have
tried to demonstrate that the pure ethical returns from a social goods
venture by an Islamic state, in this case a training programme for the
needy, plays a significant role, as indicated by the high rate of return on
zakah-induced returns. We have also tried to show in the empirical
analysis the welfare effect of zakah by establishing and estimating a
multiplier relation between income and zakah, and demonstrating the
more general relation between zakah, income and employment.
6 An Analytical Model of
Profit-sharing in an
Islamic Economy*
INTRODUCTION
Financial institutions are today evolving in many Islamic countries that

base their economic activities on the principle of profit-sharing com-
monly known in the Islamic literature as mudarabah. Such institutions
are: the Islamic Development Bank at Jeddah, Nasser Social Bank of
Egypt, Dubai Islamic Bank, Kuwait Finance House, Faisal Islamic Bank
of Egypt, Faisal Islamic Bank of Sudan, Jordan Islamic Bank of Finance
and Investment, Islamic Bank of Bahrain, National Investment Trust of
Pakistan, Investment Corporation of Pakistan, Islamic Banking System
of Luxembourg, Islamic Investment Company of Geneva, Islamic
Investment Company of the Bahamas. There are several more emerging.
While these institutions are about to undertake extensive profit-sharing
schemes in investment it is important to be aware of the inner working of
this system vis-a-vis the profit rate and the profit-sharing ratio and the
implications of these on risk diversification of investment portfolios.
THE PRINCIPLE OF MUDARABAH
Mudarabah is a profit-sharing system in Islam, whereby partners in a

joint investment venture advance capital, labour or enterprise on the
contractual agreement to share the profits of the venture by pre-assigned
percentages. The pre-assigned percentages are determined by relative
• This paper of the author was originally published under the title 'An Analytical
Model of Profit Rate-Ratio Adjustment under the Profit Sharing System in Islam and its
Implications on Risk Diversification', Haccetepe University Bulletin of Administrative
Sciences, vol. I, no. 4 (Jan. 1981).
72
AlUllytical Model of Profit-sharing in Islam 73
shares of capital advanced by each partner in the case of a capital-using

project, or by relative shares of wages forgone by labour in the case of a
labour-using project, or by relative shares of the money value of time put
in by enterprise in the case of inter-finn supervision of the joint project.
Mudarabah is more than just a principle in Islamic financial transac-
tions. It is an institution, as it totally replaces the interest on capital by a
positive rate of profit. Through its mechanism in sustaining a positive
rate of profit it serves to act as a powerful media for risk diversification,
particularly, when applied to public-private sector joint ventures. Public
enterprises are found to be only marginally risk-averse in their
investment behaviour, l particularly, because they can easily diversify the
total risk capital in the public enterprise by distributing it over a large
number of investment projects. 2 Risk neutrality on the part of the public
authority encourages real investment in the economy. Increased allo-
cation of money capital into real investment reduces the amount
available for consumptional expenditures, but only to a certain desired
level, so as to maintain an optimal allocation of capital between
consumption and investment intact. Excessive consumption, known as
israf in the Islamic literature is emphatically discouraged by Islam, and
the means to do it is the institution of mudarabah that automatically
brings about a desired allocation of money capital between consumption
and investment activity, while encouraging investment in real capital.
Finally, a positive rate of profit arrests the problem of speculative
demand for cash balances, because the ex-ante demand for money capital
is reduced to an actual demand, and this is based on a pure contractual
sharing of profits from a joint venture in accordance with relative costs
or relative capital outlays in a given production or investment.
OBJECTIVE
Three basic points emerge from the above discussion on mudarabah: (i)
Two factors affect the profit-sharing system-the profit rate and the
profit-sharing ratio. These two together would be referred to as the
'profit-sharing rate'. 3 (ii) There is an adaptive equilibrium-optimal
adjustment between the rate and ratio, on the basis of which a fair
mudarabah contract is established. (iii) This adaptive mechanism trans-
fers investment incentive to the private investor by bringing about risk
diversification in joint ventures,
The main objective of this chapter is to analytically demonstrate the
adaptive equilibrium-optimal adjustment between the profit rate and the
74 Microeconomics
profit-sharing ratios. We will then show how these equilibrium-optimal

values of the parameters create investment incentives in the individual
investor through the media of risk diversification.
OVERVIEW OF THE CHAPTER
In order to establish this premiss we shall study the profit-sharing

activity in two interrelated sectors of the economy. The first sector will
comprise the financial intermediary and a business firm. The analysis
here is made for one firm, but extension to multiple firms as partners with
the financial intermediary is summarised. The second sector will
comprise the financial intermediary and the individual investor buying
financial stocks. Here again the analysis is made for one investor, but
extension to several investors is straightforward.
The financial intermediary has two key roles in the premiss of this
chapter: first, to regulate the supply of money capital to the business firm,
and in turn be regulated by the demand for its money capital by the firm;
second, to receive cash-balances from the individual investors through
the sale of common stocks, on the promise of effective risk diversification
in the business sector.
In the first part of the mudarabah activity there will be as many shifts in
the demand and supply functions for liquidity as there are expectations
on the rate of profit earned in the joint venture. The problem of
identification that so emerges is resolved by establishing the eqUilibrium
relation equating demand to supply of money capital. Such an equilib-
rium condition, also generates the required equilibrium profit rate and
the profit-sharing ratios. The equilibrium parameters must also be
optimal, and the latter values generated from a subsidiary optimal
risk-return condition in a mudarabah contraCt, established briefly in the
following way.4
We use interdependent utility functions, Ud1l:t> 11:2, O't> 0'2) and U2
(11:1,11:2,0'1,0'2), in returns 11:1,11:2, and risk 0'1,0'2' for the two mudarabah
partners, 1, 2, respectively. We optimise U 1, subject to holding U 2
constant, with respect to the risk and return parameters. The following
assumptions are used: (i) For each contractual joint venture under
mudarabah an optimal level of total profit, set at the normal profit level, is
given. (ii) For a given level of total profit through mudarabah, the
corresponding level of risk is also determinate and given. (iii) When the
total profit and risk are optimally allocated among the mudarabah
partners, there would not be any more external benefits through
Analytical Model of Profit-sharing in Islam 75
allocative efficiency. (iv) Externality associated with X-efficiency would

exist in an optimal risk allocation situation. The usual Lagrangian
optimisation now yields (refer to appendix, p. 84),
oUt/01tt OU2 / 01t2
PtJl PtJ2
meaning that the marginal utilities of a return to the firm and to the
corporation are proportional to their prices for risk-bearing, PtJl' PtJ2'
respectively.
In the context of the argument ofthis chapter, the two interdependent
utility functions will have to be redefined in terms of the profit-sharing
rates for the two partners and their individual risk parameters. The
above optimal risk-return condition would then be rewritten as
OUA/OPA
-:--.:..:....,-,-== or:
OUs/°PB
where PAis the profit-sharing rate for partner A,
PB is the profit-sharing rate for partner B,
or: is the risk-pricing constant.
The adaptive mechanism referred to above is further rationalised

schematically through the following: ABC denotes the mudarabah
triangle, with the financial intermediary A at the pivot, supplying money
capital to business firm B, and receiving cash balances from individual
investor C. Through sale of common stocks B, on the other hand,
,
A pays
dividends ~1"d.toA
toC
8 risk diversifies C
FIGURE 6.1 Income-employment - Zakah relationship

76 Microeconomics
regulates the supply of liquidity by A. That is, B regulates A's

participation in the mudarabah contract, by trying to optimise its own
share of profits.
This push-in and pull-otT behaviour by A and B is essentially the
adjustment process in the first place, that we wish to analyse. It can be
explained as follows. Expectations of high profitability of a project
would encourage the financial intermediary, A, to outlay an increasing
amount of money capital to B in the joint venture. But this will
subsequently increase the share for A and reduce it for B. B will thereby
be discouraged to go into an external financing of this nature. Besides, as
A increases its supply of capital into investment, the marginal efficiency
of investment will start to decline. Consequently, the rate of return on the
investment will decline. In such a situation, a high and increasing share of
profit rate by A, will be an economic disadvantage for B, whose total
profit-sharing rate-not only the sharing ratio-will start to decline.
A high and increasing sharing ratio will also introduce higher risk.
This will also have to be shared by the partners under a parallel principle
known as shirakah in the Islamic literature, which says that risk has to be
shared by capital just as profits are. Increasing probability of risk will
deter A from going into increasing levels of supply of money capital, and
will deter B from demanding increasing levels of money capital from A.
Such a situation generates the process of optimal risk-return pricing
between the mudarabah partners, earlier referred to.
An argument on the existence of an equilibrium-optimal relation
between the parameters can also be forwarded by assuming that the
equilibrium profit rate sought in a joint venture is a normal profit rate. 5
We recall here that the normal profit rate is associated with free entry of
firms, each thereby exerting its influence in atTecting an otherwise
perfectly elastic demand curve for commodities, by pushing down the
demand curve and finally bringing about equality between gross revenue
and gross expenditure. 6 The cost of production thus declines in the
presence of a spectrum of profit rates adjusting to the equilibrium rate,
i.e. the normal rate of profit. In the presence of a declining cost of
production an increasing share of capital by A cannot be sustained.
Finally, in this line of arguments we can point out that, under a
mudarabah system, Islamic banks would not be in a position to create as
much liquidity as it likes based on a sheer notion of expected demand for
cash balances by creditors. This has its logical explanation. If expec-
tational demand for liquidity is not satisfied when it becomes due, there
will be recessionary pressures in the economy. The economy would
remain below potential rate of growth, underutilisation of production
capacity puts upward pressure on the cost of production. Consequently,

market prices for goods and services rise. On the other hand, if the supply
of money exceeds the demand for money there will be inflationary
pressures on the economy, for now there is too much money around, but
producers decide to cut back on production capacity and investments are
not forthcoming subsequently. By this argument, therefore, A cannot
move on to an unconstrained easy monetary policy or to a tight
monetary policy. Consequently, the capital share held by A cannot
increase idefinitely or decrease indefinitely. These arguments apply
equally to the firm B. The essence of all this is the old adage-tailor the suit
according to the size. The equilibrium-optimal profit-sharing rates help
the mudarabah partners to assess their own investment capabilities.
ANALYTICAL MODEL OF ADAPTIVE ADJUSTMENT

BETWEEN PROFIT RATE AND RATIO UNDER MUDARABAH
Let C denote the total capital requirement of the joint venture, with CA
being provided by A, and CBbeing provided by B, C = CA + CB'
P denote the annual rate of profit as defined earlier. The profit-
sharing rate is then given by,
(CAIC)p for A, and

(CB/C)p for B.
By virtue of the discussion made in the previous section, C A' CBand p
would have a spectrum of values corresponding to the prevailing
condition of risk and return, before they finally settle down to their
equilibrium-optimal values. At this stage of C A , CB , and p a fair
mudarabah contract is said to be established.
Let n denote the profit expectation.
u denote the risk.
Then, CA = CA (n, u)
C B = CB(n, u)
p = p(n, u).
In a given mudarabah contract C is preassigned.
Let, D = D(C A , CB,p, u)denote the demand for money function by B,
S = S(CA , C B , p, v) denote the supply of money function by A.
These specifications have been explained in the previous section. The
78 Microeconomics
variables u and v have been inserted in order to overcome the

identification problem in the specification of the demand and supply
functions.
In an equilibrium state of CA' CB' p,
D=S.
As a special case, take
D = a+bCA+cCB+dp+u
S = a'+b'CA+c'CB+d'p+v,
where, a, a', b, b', c, c', d, d' are all coefficients of the demand and supply
functions as they appear.
In the equilibrium state we can write
a* + b*C A+c*CB+d*p = 0,
establishing thereby an equilibrium relation among CA' CBand p.
However, as pointed out earlier, the equilibrium value of p, is the normal
profit rate, say p*. Thus, the above relation gives the equilibrium value of
C A , C B in terms of the normal profit rate, p*, i.e.
b*C A+ c*CB = - (a* + d*p*).

The optimal values of CA' C Band p, on the other hand, would be
determined by the following optimal risk-return pricing condition,
referred to earlier:
UPA/UPB = IX,
where VA = UA (PA' CT) denotes the utility of investment for the financial
intermediary. A, as a function of the profit-sharing rate, p A
= (CA/C)p, and the risk,CT.
Up A denotes the marginal utility for the profit-sharing rate, p A.
We have similar notations for,
UB = UB(PB' CT).
denotes relative-risk pricing ratio, referred to earlier.
IX
For a risk-averse investor we can take the utility function in the

following quadratic form. 7
UA = IXA + PAPA -I'AP~ - (j ACT 2 for the financial intermediary A,
and =
UB IXB+PBPB-I'BPB-(jBCT2, for the firm B.
Now, UpA = PA - 21'APA
and UpB=PB-2I'BPB.
Using these relations in the optimal risk-return condition yields an

equation of the following form:
Al +A]PA+A 3P3 = 0,
where AI> A] and A3 are simplified coefficients, and Al is a function of
the risk parameter, (1.
On writing PA,PB in terms of C A, CB and p, we obtain the equation
establishing the optimal relation among CA,CB and p, i.e.
As argued earlier, the equilibrium value of p, i.e. the normal profit rate, is
also the optimal profit rate in a perfectly competitive economy. This is
the well-known theorem of welfare economics which states: an equili-
brium relative to a price system is an optimum, and vice versa. 8 The price
system here is the risk-return pricing one.
We can now solve, for the simultaneous equilibrium-optimal values of
CA and CB in terms of p* from the two equations.
b*CA+c*CB = -(a*+d*p*)
A]CA+A 3C B= -Adp*
At these values of C A, CB given p*, the mudarabah contract is said to be
established between the part~ers.
We can now demonstrate the adjustment process among CA , CB , P in
Figure 6.2:
The negatively sloped line AB denotes the equilibrium trade-off line
between CA and CB in a mudarabah venture, with the equilibrium values
established at E, corresponding to a normal profit rate, p*. With an
expectation of increase in p, A would like to increase its share to C~.
Now, as C~ -+ C~, B's share automatically falls to C~. But, with an
upward shift in p to p', the line AB subsequently moves up to A' B',
causing the equilibrium point E' to be unstable. E' is thus driven up to
E", thus moving CB closer to its original value, C~. Now, as C~ -+ C:, C~
cannot be sustained at this value. It will therefore have to move back
towards C~. Consequently, the line A' B' must move to the left. and in the
final state. when p = p*, C... = C~. C B = C:. The same adjustment
process applies to the trade-off lines A" B" and A'" B"'. Indeed. our
formulation revelas that this equilibrium point.E. is unique because of
the assumption of risk-aversion and linear demand-supply schedule. and
is globally stable, as it remains independent of the initial value of p.9
In the case of multiple firms, the total cost of investment, C, in a
80 Microeconomics
CB*I---------'lIl
CB "I---------+--~-~
FIGURE 6.2 Adjustment process between profit-sharing ratios with varying

profit rates
diversified portfolio, is shared among m number of firms and the

financial intermediary. Aggregate demand for money function equated
to aggregate supply of money function, gives one equilibrium equation
in (m+ 1) variables. Likewise, there are m optimal risk-return pricing
conditions, making up in total m optimality equations in (m + 1)
variables. Thus, in total we have a system of (m + 1) equations in (m + 1)
variables. The equilibrium-optimal solution of the global equilibrium
system is therefore unique. Because, none of the m firms in a diversified
portfolio can be gross substitutes in the eyes of the financial inter-
mediary, therefore, the equilibrium must be indeed a globally stable
one. 10
This completes the first part of the rate-ratio setting mechanism under
mudarabah. The second part of this chapter will look at the relationship
of the equilibrium-optimal rate-ratios to individual investment decision
making.
Analytical Model 01 Profit-sharing in Islam 81
MUDARABAH AND RISK DIVERSIFICATION
The individual investor is assumed to be risk-averse. He is therefore in

search of a diversified portfolio that will yield him a reasonable return
with low risk. The private investor at the vertex C of the mudarabah
triangle would supply his liquidity to A if the latter can promise him this
reasonable return at low risk. Let us say, A sells common stocks to C on
the promise to pay C annual dividends on the profits earned in the
business sector, prorated by the individual investor's share of capital.
The objective of the financial intermediary is therefore, to maximise the
value of common stocks to the investor.
The combined problem - of A maximising the value of common stocks
for the individual investor, and the establishment of a mudarabah
contract between A and B, is cast in the following model:
max U = U (Ee> oJ
. ~ deCAPt
subject to V = t.... (1 )t
t=O +p
where U denotes the usual convex utility function with concave to the
origin preference map for the risk-averse investor,
Ee denotes the dividends received by the individual investor C,
a e denotes the risk parameter,
de denotes the dividend rate applied to the time-varying returns to
A on its investment in B, denoted by CAP" where PI> now
denotes the time-varying normal profit rates; de and CA are fixed
over time for a given mudarabah contract, as they are functions
of the initial outlay of capital.
V denotes the present value of future dividend payments to the
individual investor,
p is a representative discount rate obtained as an average of the
profit-sharing rates in a diversified portfolio, considered ad-
missible under the mudarabah contract. 11
Note further on, that
Ee = I, (E A), whereEA denotes the profits earned by A in the
business sector, using the liquidity supplied by C
through purchase of common stocks,
EA=CAP
ae = 12 (a)
Therefore the utility function for the individual investor becomes an
82 Microeconomics
indirect, or induced utility function of the parameters affecting A.11

Furthermore, since expectations on profits and dividend payments to the
individual investor are occurring over time, therefore the utility function
is indeed an intertemporal one.
The above optimisation problem is now recast as follows:
max U = U(P1,Pl, ... ,p",u/CA)
Subject to V = L"
,=0
deC
(1 APr
+p
We use the usual Lagrangian method to solve this optimisation
problem:
~ deCAP, ]
L=U(P1,Pl,···,P",u/CA)+A. [ V-""(1 _y
,=0 +p
fJL/fJpj = fJU /fJpj -A. (::C;)J = 0,

j = 0,1,2, ... , n
fJL/fJA. = V _ ± deCAp, = 0.
,=0 (1 +py
Therefore,
fJU /fJpj/fJU /fJpk = (1 + pt- i,k > j
k,j = 0, 1,2, ... , n
i.e. -dpk/dpj = (1 + pt- J,k > j, k,j = 0, 1,2, ... , n.
We can now introduce
P = (CA/C)p,
where, p denotes an average rate of return in a representative
diversified portfolio in the business sector appropriate to the mudarabah
contract. The representativeness of the diversified portfolio is essentially
determined by the rulings of the Islamic Law in matters of admissible
and recommendable investments. 13
The final result on optimal investment decision by the individual
investor is given by,
k,j = 0, 1,2, ... , n.

This result shows that the marginal rate of substitution of profits in any
two time periods is totally a function of the optimal-equilibrium profit-
sharing ratio, C,4' established earlier in this chapter, and of the
representative rate of profit p.1t is this representative rate that signals the
degree of risk diversification achievable by A in the business sector, by
indicating the proper choice of projects admissible under Islamic Law
and the mudarabah contract in the business sector, that would promise a
reasonable rate of profit to the individual investor. This is the implication
of risk diversification in this part of the chapter.
Let us explain the above result with the help of Figure 6.3. The
marginal rates of substitution given above imply that the common
stockholder would continue to hold his money in stocks in perpetuity,
moving on to longer and longer terms of investment in this way,
provided he gets the promise of a fair degree of risk diversification in the
business sector in the presence of an established mudarabah contract. A
substitution and income effect is now introduced when we consider Pi
and Pk over time. With increasing guarantee of profits through risk
diversification under mudarabah contract, private investors will continue
to invest in common stocks floated by the financial intermediary, to
longer periods of time. Thus, a shift from the point R to S indicates this
FIGURE 6.3 Substitution and income effects in optimal investment decision in

a diversified portfolio
84 Microeconomics
substitution effect on the same indifference curve. However, over time,

from period j to period k, increasing risk diversification brings greater
promise of profits to the individual investor. This introduces an income
effect, and the indifference curve shifts upwards. The point S moves up to
T on the new indifference curve. At the point T the slope of the trade-off
line is given by
-dpk/dpj = ( 1 +
C
dp)k- , k > j,
j
k, j = 0, 1,2, ... , n.
CONCLUSION
This chapter has tried to bring out the following important aspects of the
principle of mudarabah, the profit-sharing in business enterprise in
Islam:
(i) The issue of an appropriate rate of profit to be earned in a
mudarabah project. The contention of this paper has been that
this must be a normal rate of profit.
(ii) Corresponding to this normal rate of profit there is an
equilibrium-optimal value of the profit-sharing ratios of different
partners in a joint investment venture.
(iii) The equilibrium-optimal value of the profit-sharing rate that
establishes a mudarabah contract, together with the effectiveness
of risk diversification in the business sector, creates increased
propensity to invest by the individual.
The two parts of the economic model, namely the activity of the
financial intermediary with the business firm and the financial inter-
mediary with the individual investor, are consistent, since the linking
variables are the profit rate and the profit-sharing ratios.
TECHNICAL APPENDIX
1. Mathematical Formulation of Risk Allocation through mudarabah
In the text of this chapter we have set up the following optimisation

problem to determine the first-order optimality condition for risk-
sharing between the mudarabah partners (all variables previously

defined):
max U· = UI(7tI,7t2,ar, aD+A[U2(7tb7t2,ai,ai}-Ut],
meaning that we are maximising the utility function of the firm given the
utility level of the corporation as U!.
Also 7t = 7t1 + 7t2
a 2 = ar + a~ + 2ra I a 2'
The first-order conditions of maximising U· with respect to af and 7t1
are given by
dU· _ oU I + oU I . da~ +A(OU 2 + OU 2 . da~) = 0

dar - oaf oa~ daf oar oa~ dar '
dU· _(OU I OU I ) A(OU2 OU 2

d7t1 = 07t1 - a7t2 + 07t1 - 07t2 -
)_o.
From the relation
a 2 = at + a~ + 27tal a2,
by differentiating totally for a given a 2 we obtain
dar (1 + ~12)+da~(1 +r:;) = O.

Assuming now that stochastic returns of the mudarabah partners are
linearly related through a regression equation, it follows readily that
(ral/a2) is a function of the corresponding regression coefficient.
Therefore by putting
we obtain
adar + bda~ = O.
On eliminating A from the two first-order maximising equations and
using the conditions for the non-existence of externalities associated
with allocative efficiency, as given in the text of the chapter we obtain,
OU d07t1 _ oU doar
oU 2/07t2 - A· OU 2/aa~ .
86 Microeconomics
This is the first-order condition of risk allocation between the mudarabah

partners.
In the above result A is a linear function of the regression coefficient of
risky returns for the firm and the corporation. Now let further on,
-au douf = P(1I'
-OU2/0U~ = P(1z·
Now PUI. PU2. can be interpreted as the profit-sharing rates. In the
optimal risk-bearing situation they also represent the price for risk-
bearing by the firm and the corporation, respectively.
Thus
oUt/01t 1 OU 2/01t2
- A·P(1, •
meaning that the marginal utilities of a return to the firm and to the
corporation are proportional to their profit-sharing rates, respectively.
7 Microeconomic
Decision-making in an
Islamic Framework*
INTRODucnON
Two major methodological approaches can be discerned in the literature

on economic decision-making. 1 One approach has devoted itself to the
development of economic decision-making studies based on cost-
benefit techniques, 2 capital budgeting3 and valuation of industrial
projects,4 especially as the associated problems with this approach
emanates from the firm's balance-sheet and the income statement. S
The other approach to the study of economic decision-making has
been more axiomatic in nature. It applies the methodology of consumer
behaviour6 and welfare economics 7 to the analysis of decision-making
by the individual,8 the firm 9 and the state. 10 Notable in this line of
approach is the work of Vickers, which applies utility theory to the
simultaneous solution of the firm's problems of production, capital and
finance.
Apart from the methodological difference of the two approaches the
objective of the study of economic decision-making remains the same.
The principal problem of economic decision-making is one of choice
among alternatives. This involves project evaluation in the light of an
optimal structure of benefits and costs that can be generated from all
possible consideration of alternatives. 11
Some typical problems encountered in economic decision-making
are: (a) the problem of capital budgeting and capital rationing in
financing new assets; 12 (b) time-cost and trade-off in replacing old
machines for newer ones;13 (c) valuation of the net worth of the firm
from the knowledge of the time structure of cash-flows;14(d) prob-
• This chapter was published under the title' A Conceptual Foundation of Economic
Decision Making in an Islamic Framework', Humanomics, vol. I, no. 3, 1985.
87
88 Microeconomics
abilistic analysis of interrelated capital projects; 15 and (e) the analysis of

social costs and benefits in public goods investment. 16 Although the
nature of such problems is characteristically similar for decision-making
by the individual, the firm and the state, the emphasis in this chapter will
be on the latter two.
In general, therefore, we can define the area of economic decision-
making as one of microeconomic theory applied to the study of optimal
allocation of money capital among competing investment alternatives.
Optimality here signifies the choice of the most desired economic
position for the decision-maker.
OBJECTIVE
Our main objective in this chapter is to first set the theme of economic
decision-making against its appropriate theoretical microeconomic
framework. We shall then develop the relevant conceptual structure of
that theoretical framework for decision-making in an Islamic economy.
Finally, we shall demonstrate the conceptual steps involved herein, with
the help of some optimisation problems. The emphasis here will be on
decision-making at the level of the firm and the state.
MICROECONOMIC FOUNDATION OF DECISION-MAKING
The terminology, 'economic choice', is used interchangeably with

'economic decision' in microeconomics. 17 The principle of economic
choice is founded on the idea of economic rationality. The reader can
refer to Marschak's work for an elucidation of the axioms of economic
rationality.1s
Intrinsic in the criteria of rational choice is the assumption that the
decision-maker has available to him relevant information with the help
of which he can rank certain economic projects in order of preferences.
This idea of ranking alternatives in order of preferences is the
foundation of economic decision-making at all levels.
It is assumed that the decision-maker is able to make rational choices
with the help of his utility function, i.e. a mathematical relation in terms
of commodities, returns from investment, cost-benefit ratio, income
and other relevant quantities that are assumed to increase the
individual's, the firm's or the government's felicity. In this chapter we
shall be interested mainly in the forms and use of the utility function for
the firm and the government as rational decision-making agents.
Microeconomic Decision-making in Islam 89
Let us first discuss the firm's utility criterion of choice. A firm may be a
manufacturing one, a corporation or joint ownership of any of these
types. In the case of a single manufacturing firm its utility criterion is
given by a mathematical function of expected profits and risk. If the firm
is a risk-averter,19 marginal changes in the profit level will be positively
related to marginal changes in the utility level. Also marginal changes in
risk will be negatively related to marginal changes in the utility level. The
firm's utility function can, alternatively, be a function of benefits and
cost of investment, so that marginal changes in utility are positively
related to benefits and negatively related to cost. Marginal changes in
utility are also related negatively to time in order to indicate the
declining marginal utility of money over time.
In the case of the corporation or a joint partnership the utility
function is a function of the joint utility levels of the various partners or
shareholders. These latter individual utility indicators are in turn
functions of costs and benefits, or expected profits and risk. All this
means that increases in the utility levels of each or most of the individual
partners or shareholders through, say, higher expected profits and lower
risk in turn brings joint felicity of a prospering enterprise.
So much for the firm or joint partnership ventures. Let us now turn to
the government utility criterion for decision-making. The axiomatic
approach to utility analysis here is similar to that of the joint ownership
firms. The joint utility criterion is a function of the utility indicators of
the members of a representative group or community, 20 or a function of
a certain mode of income distribution considered desirable by the
government from the point of view of redistribution, price stabilisation
and egalitarianism. 21
A GENERAL MATHEMATICAL FORMULATION OF THE

UTILITY CRITERION FOR DECISION-MAKING BY THE
FIRM AND THE STATE
The nature of the corporation's and the state's utility criterion for
decision-making as discussed above can now be put down in a unified
mathematical form for quantitative work.
Firms make investments the returns and costs from which accrue over
time, depending upon changing patterns of tastes, earnings and risk. 22
The decision problem for the firm then is one of allocating its money
capital between consumption services and investment, intertemporally.
The government may use the general form of the utility function to
90 Microeconomics
obtain economies of scale in interdependent projects across various

sectors of the economy.23 In this case the axiomatic approach to
investment decision-making also serves as a basis for policy-making.
For example, when marginal cost of production condition indicates
optimal scale of use of an existing capital good, it is actually a
comparison of total costs of production that determines the choice of
investment alternatives. The policy implication that follows is that a
control of the cost of investment together with the price of the output
can help achieve all the external economies. It has been found that in
sectors with high economies of scale the correct initial investment is
critical. This calls for government ownership and price administration in
those sectors, particularly in developing countries. 24 The point raised
here shows how a general form of the utility criterion used for making
interdependent investment decisions is used for the government.
The general mathematical form of the utility criterion can now be
written down as follows:
Let ql = qt<G\, Ed denote a functional of the time-dependent
sequence of costs and benefits in investment alternative 1, with
(;1 = (C l l ' C w ... C ln ); C li denoting costs in time period i,
(i = I, 2, ... , n t ), in investment alternative 1;
lit = (Bll' B t2 , . . . , BIn.); B li denoting benefits in time period i,
(i = 1,2, ... , n l ), from investment alternative 1.
Likewise, we define for investment alternative 2, the functional,

q2 = q2 (C 2, B2)'
In the case of optimal investment decision-making for the firm or
corporation ql' q2 maybe taken as the present value of cash-flows from
the two alternatives, or present value of cash-flows for two shareholders
from their shares of common stocks, respectively. The two sequences of
cash-flows may be statistically independent or interdependent. 2s
In the case of optimal investment decision-making for the govern-
ment, say, with the objective of deriving maximum external economies
in given sectors of the economy, ql' q2 represent functionals of the time
dependent total social costs and social benefits from selected invest-
ments in given two sectors of the economy. By the argument presented
earlier, in sectors where external economies are high, comparison of
total cost serves as the criterion for choice of investment, and the
marginal cost condition, which must be equated to price, indicating
benefits from production, serves to imply the optimal scale of use.
Microeconomic Decision-making in Is/am 91
Now the utility indicator in the case of a single firm, the corporation
or the government (public authority) is given by
(I)
In the case of the single firm ql' q2 may represent the present value for
independent projects. In the case of the corporation they are usually
interdependent. The utility indicator U is then said to be interdependent
utility indicator. 26
In the above explanation qb q2 have been taken as functionals which
could also be more decentralised utility indicators, functions of
cost-benefit ratio, profit, risk, etc. In the above general form the utility
indicators for the corporation and the government are appropriately
referred to as welfare functions for the two levels of decision-making,
respectively. Expression (1) can therefore be alternatively written as
W= W(B, C). (2)
It is logical that the single firm would derive higher levels of felicity
from increasing levels of benefits, but decreasing levels of costs. In the
case of the corporation, it isinvariably assumed that the corporation acts
in the best interest of the shareholders, because optimizing dividends to
the shareholders implies optimising the corporation's value of the shares
of common stock and its net worth. Therefore, again we have the
marginal relations of welfare to costs and benefits. In the case of the
government, it acts in the best interest of the firms generating external
economies by taxing firms that produce external diseconomies and
subsidising firms that produce external economies. The state's objective
is to maximise social benefits and minimise social costs. Therefore, again
we have the marginal relations of welfare to social costs and social
benefits. The mathematical completeness of expression (2) in the light of
these arguments is
W= W(B, C)
with aW/aB > 0 (3)
aw/ac < o.
OTHER FORMS OF DECISION-MAKING FUNCTIONS
Other forms of decision-making functions are: the profit function,

present value of cash-flows, internal rate of return criterion and the
92 Microeconomics
cost-benefit ratio criterion. However, it can be shown that these are

special cases of the general form of the welfare function for investment
decision-making.
The superiority of the welfare function for investment decision-
making over the other forms of decision-making functions is founded on
its greater analytical capacity to explain a wide range of motives of the
decision-maker in setting up his rationale of economic choice among
given alternatives. For example, the decision-maker's objective could be
to achieve a desired distribution of income rather than profit maximis-
ation, risk-aversion rather than present-value maximisation, optimising
social benefits rather than private benefits, and so on.
A general form of the welfare function applied to society at large is
that presented by Samuelson. 2 7 The Samuelsonian form of the welfare
function is a function of an infinity of cardinal indices, some economic
and some non-economic. Besides, individual utility may have arbitrary
curvature of the loci of indifferences. The only assumption for the social
welfare function is that it must be capable of providing a definite
ordering of social choices, i.e. whether one attainable state of the
economic system is 'better off' or is 'worse off' than any other, or is
'indifferent' to alternative states.
The cardinal indices are not all independent of each other. Between
them there will be a number of relations limiting the freedom of varying
all the indicators independently. The relations will be determined by the
value judgements in respect to the technological constraints of consump-
tion and production and other non-economic constraints of the
decision-making units.
The Samuelsonian type of the general social welfare function is found
to be particularly useful in analysing social resource allocation in a dual
economy and an economy which is at the same time highly ethical in its
value orientation. A singular example of such a dual economy, which is at
the same time highly ethical in values is the Islamic economic system. 28
This brings us to a discussion of the topic of economic decision-making
in an Islamic framework.
DECISION-MAKING IN AN ISLAMIC FRAMEWORK
The existence of an appropriate form of the welfare function for

investment decision-making is essential in an Islamic economy in order
to allocate the resources of this economy optimally or in a desired way
among competing alternatives. Before we can develop a quantitative
form of the welfare function we need to define certain required terms for
operating in this new economic system.
Resource
The general idea of resource in Islamic economics is centred around two

main points: (i) its availability, (ii) its management and utilisation. With
regard to the Islamic viewpoint on resource availability the Quran
speaks of abundance 29 and that resource in the universe exists in perfect
harmony and balance with the living world. 30 With regards to the
Islamic viewpoint on resource management and utilisation the Quranic
injunction is the efficient and righteous use of the good things that God
has created for the service of man,31 who in turn is but only the
vicegerent of God entrusted for the just use and distribution of His
resources.32
The categories of resources that would belong to this definition of
resources are: natural resources, human resources and the worldly
equivalent of the resources of Islamic belief (taqwa and akhira) in so far
as they augment our economic activities. Natural resources are consid-
ered abundant in Quran because God has made infinitely many
substitutes of each form of natural resource, and He has ordained man to
use them in the strict absence of waste,33 for the achievement of co-
operation in production and consumption 34 and the realisation of
balanced economic growth. 35
The last type of resource of an Islamic decision-making process needs
to be explained further. Let us take an example. In an Islamic state where
zakah is an organised form of social assistance, the readiness on the part
of the individuals and firms to pay zakah stems from their strength of
Islamic belief on the akhira and on taqwa. The funds from zakah social
assistance programmes then generate secondary and external benefits
through income redistribution, increased training and others. The pure
Islamic obligation to pay zakah, therefore, augments certain pure
economic activity while causing subsidisation of the needy by the rich
without social and political friction. This higher resource factor, which
plays an important role in decision-making in an Islamic framework is
associated with what is known as maqasid al-shariah, i.e. 'the basis of an
integrative or systematic approach to Islamic values distinguishing
between universal goals and principles on the one hand and instrumental
goals and specific applications on the other hand so as to define the
hierarchy of values in Islamic law. 36
94 Microeconomics
Cost
Based on the idea of total resource in Islamic economics the idea of cost
in an investment alternative in this framework will also change. The idea
of cost in Islamic economics is one of total cost, i.e. the pure economic
cost plus the 'non-economic' cost component. The non-economic cost
component may be either associated with the idea of a Muslim's
punishment in the akhira subsequent to his indulgence in wasteful
consumption in this world or it may also be expressed as zakah, sadaqah,
etc., which are fundamentally associated with the Muslim's pure Islamic
belief. In the round of secondary and spill-over effects the pure non-
economic cost component associated with israf (wasteful consumption)
results in the pure economic cost measured in wastage of factors of
production, increasing cost of social assistance, decreased allocation of
money capital to real investment and lower rate of profit and growth for
the economy.
The recognition of the cost of wasteful consumption in an Islamic
economy warrants a characterisation of the consumption patterns for
this economy. The basic feature for consumption-investment constraint
on capital allocation in an Islamic economy is the following:
(i) The Islamic society gives consumption priorities to the necessaries
and comforts of life in this order. The production and consumption of
luxuries in so far as they cause israfis prohibited. 37
recommended, for this creates wastage of factors of production and of
produced goods.
and comforts of life and more capital goods over time, that increase their
productive capacities over time is highly encouraged. 38 Such is indeed
the way in which production, growth and development proceed
intertemporally. If now the form of the total cost function is
c = C (CE, CNE~ (4)
where CE denotes pure economic cost component,
CNE denotes pure non-economic cost component,
the minimisation of this total cost function may not imply the
simultaneous minimisation of CE and CNE. When CNE is associated with
israfit must definitely be minimised, but when it is associated with zakah
it is not necessary to minimise it depending upon the relation of zakah to
the firm's investment level. In the conventional economic system there is
no parallel concept of minimising C NE when associated with high level of

consumption. 39
A difference is to be made when CE denotes the pure cost of
investment. Then C NE may denote the pure non-economic cost of
investment in machines that produce wasteful luxury goods. In this case
the decision-maker in an Islamic economy need not look for a
minimisation of C E per se, for investment in capital goods would be high
in an Islamic economy, so also would be investment in human capital.
The Islamic decision-maker, however, does look for the best combi-
nation of investment alternatives satisfying his desired objective. The
cost component, C NE , would still be minimised, thus steering away the
Islamic economy from a high-consumption state. 40
Benefit
Like the idea of total cost we have also the idea of total benefit in an
Islamic economy. Total benefit comprises the pure economic benefit,
which in an investment decision-making would be derived from an initial
outlay of pure economic cost, C E' allocated over a most desired
combination of assets. The pure non-economic benefit component is a
worldly equivalent of the pure Islamic belief on taqwa and akhira that
augments the pure economic benefit component. In this sense the pure
non-economic benefit may be interpreted as external benefit emanating
from an altruistic but integral sector41 of the Islamic economy, resulting
from a related constraint of minimising C NE as external diseconomy, and
having its important role in the flow of goods and services in the
economy as a whole. 42
Let the total benefit function be of the general form
B = B (BE' B NE ), (5)
where B denotes total benefit,
BE denotes the pure economic component of benefit,
BNE denotes the pure non-economic component of benefit.
BNE can be quantified in an Islamic economy through increased labour
productivity, employability and earnings (all of which would denote B NE )
generated by zakah-funded employment creation programme for the
needy. In an investment undertaking of the firm, C E may denote the
outlay in investment based on the firm's profit maximisation motives.
CNE would denote the Islamic firm's obligatory altruistic expenditure.
96 Microeconomics
Consequently, BE would denote the benefit derived as a result of the

outlay ofCE , and BNE would denote the benefit from C NE • Although the
Muslim's motivation to incur the cost of C NE is based purely on his
Islamic obligation, and the resulting benefit, B NE , represents his reward in
the akhira, the worldly equivalents of these forms of pure non-economic
elements of Islamic belief appear in the form of increased labour
productivity, higher levels of employment and earnings, all of which
augment the pure economic quantities. BNE thus becomes measurable
and plays an important role in decision-making in the altruistic sector of
the Islamic economy.
Time
Intertemporal investment decisions are made over the lifetime of a

project. The costs and the benefits from such programmes accrue over
the corresponding period of time. However, the nature of the Islamic
total costs and benefits indicates that Islamic economic decision-making
must conceptually be based on a programme of resource allocation
involving not only a finite time horizon, but also a transcendental time
horizon. The transcendental time horizon is conceptually different from
the infinite time horizon as it is associated with the non-economic costs
and benefits per se. However, for our analysis we shall treat it as an
infinite time horizon.
Total time in an Islamic economic decision-making is conceptually a
function of the intertemporal time component, denoting the time
horizon over which the pure economic benefits from an investment
programme accrue, and of the transcendental time component, over
which the pure non-economic costs and benefits of an Islamic altruistic
programme accrue. Conceptually the latter component of time as we
have defined it cannot be of any interest to us in quantitative decision-
making, and must therefore be transformed into its intertemporal
component, augmenting thereby the pure intertemporal component of
the time horizon of an investment programme.
The problem of reducing the transcendental time component into its
intertemporal component is an intricate mathematical one. A few studies
have been made concerning optimal investment programmes over
infinite time horizons. 43 The difficulties that arise are of two types:
(i) Over an infinite time horizon the existence of uncertainty could make
time-dependent cash-flows stochastic in nature, and here the estimation
of the returns becomes complex.44 The occurrence of stochastic
processes45 of time-dependent returns generates non-convergent object-

ive criterion for decision-making. 46 (ii) There is also the difficulty of
fixing a terminal date after which the proportion of output going to
investment would be zero and the system will refuse to add to the
terminal value of the capital stock. 47
In the light of these conceptual difficulties involved in infinite horizon
investment-consumption decisions, we shall propose to convert the
transcendental time component into its intertemporal component by the
following method.
After a terminal point, when a terminal stock has been determined for
an investment programme, the economic interest in capitalising the value
of the investment for longer time periods will be of no interest. The
benefits from an Islamic altruistic programme would however, still
continue.
Let these net benefits from an Islamic altruistic programme be
denoted by,
(B T , B T + 1 , ••. )
where T denotes the terminal point for the pure economic benefits from
the firm's investment.
Corresponding to this sequence of net benefits is a utility function; the
decision problem now is 48
max U(B T , B T + 1 , ••• )
00
subject to PT = L: Btx t (6)

t = T
where PT denotes the present value of B t discounted by x t ,

t = T, T+ 1, ...
Now by a suitable choice of techniques in production with the help of
investment in capital goods the firm can in fact be faced by a whole range
of values of terminal points corresponding to an infinite (or very many
but finite) set of benefits, generating a sequence of ordered utilities, and
therefore, present values from the Islamic altruistic programme. The
terminal value of the capital stock is itself expected to affect the benefit
stream from the Islamic altruistic programme. Thus, in the presence of a
stochastic sequence of benefits corresponding to an indefinitely large set
of choice of techniques we would have a probability limit for the
sequence of present values of the different benefit streams. This
probability limit of{p.}, with s = T,T+i,T+k, ... ,wherei,k, ... ,are
98 Microeconomics
arbitrary numbers, will determine in the equivalence sense and by

interpolation on the time component,49 the time period over which a
valuation could be done of the economic equivalent of the pure non-
economic benefits of the Islamic firm's investment. This would transform
the transcendental time component associated with an Islamic altruistic
programme, to an intertemporal time component.
We can now formalise the above argument in the form of a general
expression for the total time function in the valuation of the total costs
and benefits from an investment in an Islamic economy. This time
function would be given by
(7)
where t 1 denotes the intertemporal time horizon associated mainly
with the pure economic benefits;
t~ denotes the intertemporal equivalent of transcendental time
horizon associated mainly with the worldly equivalents of the
pure non-economic benefits from an Islamic altruistic
programme.
OBJECTIVE FUNCTION
The key economic factors, namely, resource, cash-flow and time, play
their important roles in economic decision-making in an Islamic
framework just as in a conventional economic framework. However, as
explained above, the nature of these key factors change radically in an
Islamic framework. In the conventional economic set-up these key
economic factors help to distinguish between the critical responses for
decision-making and the non-critical responses. so In an Islamic set-up,
too, the idea of total resource, total cost and total benefits in respect to
the transcendental time variable will be operationalized by the laws of
shariah in providing the critical response to an economic decision-
making in the Islamic framework.
The operationalising of the laws of shariah on the three key factors:
resource, cost and benefit over time for decision-making in an Islamic
framework can be effected with the help of the welfare function. The
following will be the basic nature of that welfare function: s 1 The laws of
shariah will be the main instrument in defining the cardinal indicators of
the social welfare function as well as the relations among the cardinal
indicators. Three economic conclusions come out of this: (i) that the
utility indices comprising the welfare function must develop some type
of pre-ordering of preferences for consumption, investment and social
states; (ii) that individual actions in this regard are limited to the extent of
conforming to the laws of shariah; that the progressive assimilation of
the laws of shariah in the lives of the decentralised decision-making units
makes social actions and preferences a fair reflection of the more
decentralised preferences, and this reduces the indeterminacy of the
social welfare function; (iii) that the determination of conditions of
optimum social welfare must now be carried out in a non-market setting
too.
Let the general form of the welfare function, well-defined in the above
sense in terms of the three key factors of decision-making be
(8)
where C, B, t, CE, CNE , BE' BNE , t l , t; have been defined earlier.
W being in cardinal form is a mathematical function with continuous
first- and second-order derivatives. Thus,
oW/oB > 0, oW/oC < O.
In an Islamic economy the sign of oW/ot could be either positive or
negative. It could be positive because we do not have the parallel notion
of time-preference in Islamic economics-a product truly of the neo-
classical consumption theory of interest. 52 It could be negative in case of
consumptional wastage, capital consumption and unrecovered capital
cost over time. These are signs of dynamic inefficiencies from which the
society derives lower and lower levels of social welfare.
Finally, in this section for a word on the geometrical form of the
welfare mapping. 53 The grand utility-possibility frontier in the conven-
tional welfare analysis is not strictly convex to the origin. This is due to
the fact that the marginal rates of substitution and transformation of one
commodity for another in the production and exchange mechanism are
not the same for all individuals or firms. Consequently, the production
isoquants are not homothetic. 54 The implication of this is that the
various firms involved in the production and exchange mechanism face
different relative factor prices or have different modes of production.
In an Islamic economy different relative factor prices cannot exist for
the two firms. Also the marginal rate of substitution is affected not by the
production function, but by the mode of production, which in turn is
affected by relative factor prices. Therefore, the exchange of factors or
commodities between the two firms can be so arranged that the contract
curve is diagonal within the production possibility box. 55 In such a case
the marginal rates of substitution and transformation of one factor or
commodity for another factor or commodity for different firms will be
100 Microeconomics
equal in magnitude. The implication of this is a strictly convex to the

origin grand utility-possibility frontier and the strictly concave to the
origin welfare indifference maps.
SOME MATHEMATICAL CONSTRUCTS OF DECISION-

MAKING PROBLEMS IN AN ISLAMIC ECONOMY
Having so far discussed the theoretical constructs of the economic

decision-making problem in an Islamic framework, we shall now see how
to operationalise them quantitatively. To accomplish this objective we
shall introduce the following two mathematical investment decision
problems in an Islamic framework.
Use ofthe Welfare Function in Evaluating the Benefits from a Zakah-

funded Programme
Let us pose the problem in the following way: a firm is deciding to put its
zakah funds at the start of the fiscal year on training the poor on a
programme of training of the handicapped poor whose services it could
later on use. It is expected that this programme would improve the
employability and earnings of the trainees. Thus, corresponding to an
initial outlay of zakah, the benefits from the programme could be
thought of as higher employment rate and earnings for the recipients,
and. a fulfilment of Islamic duty by the firm. All this belongs to a higher
interpretation of human capital. 56
Also there could be an inverse relationship between zakah and
investment, for more money circulating in the form of real investment
will reduce the project-specific rate of zakah. Consequently, at a
particular time, the reduced amount of zakah in this way could generate a
correspondicgly lower amount of benefits related to the zakah
programme.
All this can now be expressed in mathematical equations. We shall
now isolate the zakah programme as a separate one in the firm's decision-
making milieu. With this qualification, note that an operational
distinction between the pure economic cost or the pure non-economic
cost attributable to zakah may not be made. However, if, in line with our
previous argument, we associate zakah with C NE and the benefits from
the zakah programme with B NE , we still have a well-defined viable sub-
problem in decision-making for the firm.
Let the welfare function related to the zakah programme be as follows:

W = log (B/Z)G, (9)
where W denotes the welfare level. It is of cardinal type, being a function

of B, the benefit from the zakah programme, with a zakah
outlay of Z at any time,
a denotes the elasticity of welfare with respect to the benefit-cost
ratio,
B/Z, a ~o.
The relationship among zakah, the firm's other investment and the
benefit from the zakah programme would be
B = za'/Ia z (10)
where at denotes the elasticity of B with respect to Z, at ~ 0,
a2 denotes the elasticity of B with respect to I, a2 ~ 0,
I denotes the investment level at any given time.
We also have the relationship between zakah and investment, as
explained earlier, given by
Z = A/la 3 (11)
where A denotes a positive constant,
a3 denotes the elasticity of Z with respect to I, a3 ~ o.
The decision problem for the firm related to the zakah programme is
the following: s7
Max W= log (B/Z)G}

subject to B= za'/Ia z (12)
Z = A/la3
The Lagrangian for this optimisation decision problem is given bys8
L = max (log (B/zt-pdB-za'/Ia z )-P2(Z-A/la3 »,
where Pt , P2 denote Lagrange multipliers or shadow prices. Pt, P2 can
likewise also represent marginal costs, in which case they may not
necessarily be positive. Negative shadow prices would indicate the
presence of external economies.
The first-order optimality equations related to this decision problem
are,
aL/aB = 0, i.e. B = at/Pt (13)
102 Microeconomics
aL/az = 0, i.e. Pl(a l B/Z)-P2 = a/Z (14)

aL/a] = 0, i.e. Pl (a2B) + P2(a3Z) = O. (15)
Expression (13) is only trivial since its use in equations (14) and (15)
does not establish a required optimal relation between zakah and benefit
to indicate the usefulness of the zakah programme to the firm. We
therefore, solve for Pl' P2 from equations (14) and (15). This gives
Pl = - (aa3/(al a3 - a2)) (16)
P2 = (aa2a3/(a3(ala3 - a2)Z2)). (17)
Since Pl' P2 are arbitrary shadow prices we can take them in the
normalised form and write without loss of generality,
Pl + P2 = 1. (18)
Now, by substituting the values of Pl and P2 from expressions (16) and
(17) into expression (18), we obtain the zakah-benefit relationship sought
for,
(19)
Expression (19) gives us the optimal relationship between zakah and
the benefits from the zakah funded programme. It shows that, irrespect-
ive of what the level of pure investment is, there would be a multiplier
relationship between zakah and the benefits of the zakah programme.
We can rewrite the result (19) in the following form,
(20)
In this form the left-hand side of the expression denotes the welfare
derived by the firm and the right-hand side denotes the welfare derived
by the zakah trainee. The two are perfectly conformable up to a scalar
factor. The optimal combination of the two welfare functions appear
along the diagonal to a continuous sequence of rectangles as shown in
Figure 7.1. This optimal combination corresponds to the multiplier
relation in the Z-B diagram.
Constrained Intertemporal Welfare Maximisation: an Example in

Investment, Capital and Discount Rate Relationship in an Islamic
Economy
We shall here look at an example of an Islamic welfare function, its

intertemporal constrained maximisation and the resulting relationship
log (B/Z)
I--',,-,-":";"'''':'':''''',{- - - - - - - I------~
L -_ _ _ ~ ___ ~
log (a3/a2)Z
"""'"-------'-----''---Z
log (a3/a2)Z, log (a3/a2 )Z2 Z,
FIGURE 7.1 The zakah-benefit multiplier relation and conformable utility

frontier
between the discount rate and the investment level and between the
discount rate and the capital stock over time.
Let us define Y, as the Islamic return, which is the sum of the pure
economic returns and the economically imputable non-economic re-
turns. Empirically, it is difficult to estimate Y,.S9 However, the cor-
respondling level of investment is more easily estimable. We shall
therefore, take the welfare function in the form 60
U = U(I" i)
where I, denotes the investment at time t,
i denotes the investment rate, i.e. I, = Ioe i'.
U is essentially an intertemporal utility function. We shall take it in the
risk-averse form for an Islamic entrepreneur, i.e.,
U(I, i) = A exp (- (1%1/ + 1%2i» (21)
where A < 0, 1%1 > 0, 1%2 > 0.
au
Clearly iii > 0,
au
Ti>O'
a2 u
01 2 < 0.
104 Microeconomics
In other words these expressions mean that the investor would like to
invest in risky ventures provided the Islamic returns from it are high, and
he is encouraged to do so by a higher assumption of total risk by the
Central Treasury in a mudarabah contract. Likewise we also have the
similar conditions for i.
Intertemporal maximisation of social welfare would now require,61
max r. e-~U(I: .)dl }

(22)
Subject to Q = I + pI,
where p is the capitalisation rate in an Islamic valuation model,
Q is the output level.
The constraint of the maximisation problem can be written as
Q .
I=I+P
. dQ .
I.e. dK = I + p, (23)
where K denotes the capital stock.
r(
The usual way to solve the given maximisation problem is to introduce
the dynamic Lagrangian multiplier, A., and maximise the following:
max e-P'U(I, i) + A. (~i - i - P))dt. (24)
The Hamiltonian for this maximand is given by
H(l, i, A.) = A exp (- (pt + all + a2i» + A. (~i - i - p). (25)
Treating I as the state variable and i as the control variable the

canonical equations would be
0;: = - A., i.e. Aal exp (- (pt + all + a2i» =i (26)
°a~ = 0, i.e. A a2 exp ( - (pt + al 1+ a2i» + A. = 0, (27)
if i = constant, i = O.
We then obtain from the two equations on A.
i= Aa2(P + ali) exp (- pt - all - a2i) (28)
and therefore,
-. «(%11 + p) = 1, i.e. I • = -1 ((%1

(%2' )
- - p .
(%1 (%1 (%2
• (%1
Now I ~ 0, provided p ~ -.
(%2
Then
l(t) = ~((%1 - p)t +10 (29)

(%1 (%2
1 ((%1
K(t) = -2 - - p}2 +lot+Ko· (30)
(%1 (%2
For simplicity in estimation, at!a2 can be taken as unity. This is

meaningful because we are considering investment to be increasing at a
constant rate, so that the risk-aversion coefficients ai' a2 would be nearly
equal. Now, p ~ 1, the usual constraint for the capitalisation rate.
The lower is p either due to a decline in the marginal efficiency of
investment and/or the price for risk-bearing in an Islamic economy, the
higher will be the time profile of investment. The same is true for the time
profile of the capital stock.62
We can further write down the p - l(t) - K(t) relationship in the
following equations:
K(t) = ~ (l(t) - 10 ) + K o, which is the K-l relation, (31)
and
1
K (t) = -2
(%1
(a 1 -
(%2
p) t 2 + lot + K o , which gives (32)
the time profile of the capital stock in relation to p. These relations can
now be represented in Figure 7.2.
First let us take a cross-sectional look at Figure 7.2 with time fixed.
The left-hand side of the figure shows that, as p decreases, the capital
stock increases and consequently the investment level increases, shown
by the capital-investment relation, AB. p = 1 is the upper ceiling for the
capitalisation rate, corresponding to which, I = 10 , K = Ko. For a fixed
time period, p = 0, gives a capital stock of Kl corresponding to which
there is an investment of II. We now wish to find out what can be the
magnitude of K 1 , and therefore, whether p can in fact be zero and, if so,
at what time period.
106 Microeconomics
K K 8
K' K'
11
FIGURE 7.2 P-I-K relatwnship in an Islamic economy
Let us introduce the time variable on the three-dimensional, K-J-t

plane as shown. Now, for P = 0, Kl is no more a constant but increases
with time. So also does J. We can interpret this by observing that, as
P -+ 0, K, J increase indefinitely as the time period increases indefinitely.
That is, a zero rate capitalisation is a phenomenon of the very long run,
and is associated with an indefinitely large volume of capital stock and
investment flow. Therefore, for all practical reasons of capital valuation,
we should not be looking for a capitalisation rate equal to zero in an
Islamic capital valuation model.
CONCLUSION
In this chapter we have attempted a development of the welfare basis of

economic decision-making in an Islamic framework. This approach has
been shown to be superior to and more general than the alternative
approaches, such as profit maximisation, cost-benefit ratio, internal rate
of return criteria of choice among investment alternatives. The emphasis

in this chapter has been placed in the quantitative approach to decision-
making at the level of the firm and the state in an Islamic framework.
This is boldly attempted without risking the intrinsic link of the
quantitative models developed here with the inner philosophy of the
Islamic values in the new framework of economics.
It is hoped that the models developed in this chapter can be actually
tested with the help of empirical data in subsequent studies. If this can be
done, and the possibility of that is not remote, then the models suggested
here can also serve as quantitative policy instruments for recommending
the mode and forms of capital formation, real and human, in an Islamic
economic framework.
8 Formation of Social
Ordering in an Islamic
Welfare Economy*
THE CONTENT OF MODERN WELFARE ECONOMICS
Welfare Economics and Optimal Allocation of Resources
Welfare economics is the study of optimal allocation of resources for

achieving social welfare. The premisses on which the methodology of
social welfare analysis are based are the structure of preferences and
tastes of the individuals who comprise a society and the societal
preferences of rational alternatives formed by the hedonistic pains and
pleasure calculus of the individuals. The philosophical underpinning of
welfare economics is therefore beset by the tastes and preferences of two
competing economic agents, on the one hand of the individuals who
have their pre-modal tastes and preferences, and on the other hand the
society's priorities of ordering its preferences, often conformable in
some sense to the collective tastes and preferences of its members.
A social ordering cannot be imposed on the individual, for then the
value of welfare analysis in a market setting will disappear.
Consequently the problem of optimal allocation of resources through a
market mechanism for the ultimate attainment of certain social goals
will cease to be of interest. Thereby, the branch of welfare economics will
be deprived of its theories of Pareto-optimality and the second-best.
However, although the state cannot impose its preference for social
ordering on the individuals it is possible to transform the outlook of a
people, and through a process of political and social change bring
individual preferences close in conformity to social goals. When such a
.. Reprinted from An Islamic Sociol Welfare Function (Indianapolis, Ind.: American

Trust Publications, Jan. 1983).
108
Formation of Social Ordering in Islam 109
state is reached, individualistic ethics, values and preferences are said to

be correctly represented in social preference ordering.
A Comparative Look at the Framework of Welfare Economics

In the capitalistic framework of welfare economics the idea of consumer
sovereignty rules supreme. The Smithian and Marshallian postulates of
market exchange are overplayed upon, and what results is a social
welfare function defined by the collective expression of individualistic
preferences formed independently in the media of free competition
where consumer sovereignty finds its nesting ground.
In the socialist, dictatorial or totalitarian forms of governments,
market mechanism of allocating resources is ignored. Social ordering of
given alternatives is then said to be imposed, 1 in so far as it is not formed
by individual preferences. The social welfare function of such forms of
government then turns out to be a means of normative valuation of
income distribution based on subjective notions of marginal utility of
income. Such a normative valuation of income distribution could
actually be quite different from the actual valuation of income
distribution with individual preferences explicitly built into a social
welfare function. 2
The exclusiveness of defining social welfare function in terms of
prices, marginal costs, marginal utilities of income, consumption and
commodities, is an incomplete picture of total welfare. The economic
problem of welfare analysis is one of choice, but choice among what?
Food, clothes and consumption form only a small part of the greater
choice of alternatives by individuals to reach optimum social welfare.
Such choices are often controlled by non-market forces, but must be
brought within the purview of the social welfare function in order to
explain not only what the economic causes of welfare are, but also what
causes this total welfare. 3
It was Professor Robbins4 who for a long time swayed the minds of
economists away from this broader concept of social welfare by
advocating a complete independence of modem welfare economics from
ethical value judgements. This was, of course, a smacking of the
individualistic philosophy of Western civilisation, i.e. to formulate a
social welfare function in the 'pale' of consumption and production
mechanism alone.The world of welfare economics is thereby charac-
terised by a set of commodities for consumption and a set of productive
services. The total value of these commodity and production sets is then
distributed among a given number of individuals in the system.
110 Microeconomics
Such is also the way in which Debreu s defines his general equilibrium
welfare system: an economy is completely characterised by a consump-
tion set for each consumer, with his preference pre-ordering, a
production set for each producer and the total resources. The preference
pre-ordering determines an optimal allocation of resources with respect
to a price system, provided in such a state it is not any more possible to
better the satisfaction or the preferences of a consumer without injuring
the satisfaction or the preferences of another consumer, given the same
amount of resources. Here again is the evidence of economic welfare
being defined totally in terms of Pareto - valuation optimum in
reference to a price system. The schizophrenic nature of modern welfare
economics of achieving social welfare optimum on the one hand and, on
the other, restricting the media of analysis to a price system is all-
pervading in modern economic analysis.
The Social Welfare Function
Given that individuals frame their own tastes and preferences in-
dependently in a consumption-production environment, a social welfare
function turns out to be an ordinal index of individual utilities, and
therefore also an ordinal index of societal welfare. The individual
utilities are essentially non-unique. Therefore, the social welfare func-
tion in terms of individual utilities is not uniquely determined. This
indeterminacy of the social welfare function is reduced by treating
consumers as substitutes. What follows from this assumption is the first-
order condition of Pareto-optimality:6 equate the rate of commodity
transformation for different groups of consumers to the corresponding
rate of product transformation.
The indeterminacy of the social welfare function is, of course, reduced
in the case of a totalitarian form of society, for in this case it is useless to
talk about individual utility functions. The overriding factor now is the
value judgement of the regime or state in stating set forms of social
norms, particularly with respect to income distribution, and then
imposing it on the individuals. The social value judgements, as in the
case of the capitalistic form of the social welfare function, are again
determined by technological constraints of consumption and
production.
It was remarked earlier that in the case of a totalitarian form of
government the social welfare function serves as a means for a
normative valuation of income distribution. Lange 7 has shown that for
such a communal form of government social valuation can be made
directly in terms of incomes and commodities without it being necessary

to look at individual utilities. A direct social valuation in terms of the
distribution of income is more feasible than a direct valuation in terms of
commodities, as the latter involves subjective knowledge of marginal
social utility of each commodity in the hands of each individual in a
community. Using the former form of valuation for a socialist economy
it is shown that, for the 'marginal social significance' of each individual
to be the same, each individual must be paid the same income.
Samuelson's framework of the social welfare function, on the other
hand, is more general, in that it does not restrict the social welfare
function to strictly economic variables. The Samuelsonian welfare
function 8 is a function of an infinity of cardinal indices, some economic
and some non-economic. Besides, individual utility indices may have
arbitrary curvature of the loci of indifferences. The only assumption for
the social welfare function is that it must be capable of providing a
definite ordering of social choices, i.e. whether one attainable state ofthe
economic system is 'better' or is it 'worse' than any other, or is
'indifferent' to alternative states.
The cardinal indices are not all independent of each other. Between
them there will be a number of relations limiting the freedom of varying
all the indicators independently. The relations will be determined by the
value judgements in respect to the technological constraints of con-
sumption and production and other non-economic constraints, of the
state or the individuals.
The Samuelsonian type of general social welfare function is found to
be particularly useful in analysing social resource allocation in a dual
economy and an economy which is at the same time highly ethical in its
value orientation.
THE CONTENT OF ISLAMIC WELFARE ECONOMICS
Social Welfare Concept Based on the Tenets of Islamic Law
A singular example of such a dual economy, which is at the same time

highly ethical in values, is the Islamic economic system. An Islamic
economy gives similar priorities to resource allocation as any other
system, but the significant difference is that the 'con~traints' or the social
relations of consumption, production and other social goals binding the
cardinal individual utility indices of a general social welfare function are
determined by what is termed as the 'Law of shariah '.
The shariah provides the fundamental legal system derived from
112 Microeconomics
Quran, supported by the traditions of Prophet Muhammad and

extended by analogy of the learned Islamic scholars at different points of
history. The domain of shariah covers all aspects oflife. The shariah is in
fact the Islamic means for practically integrating religious belief with the
mundane affairs of human society. The highest stage of this assimilation
is signified by the insuperability of the Muslim daily life, private and
public, from the Islamic code of conduct. Indeed this is how Islam is to
be taken in the polity of the state and the individual.
The principal essence of shariah is tawheed, meaning unity. Let us
explain this principal of tawheed in the socioeconomic context. The
power and practicality of the principal of tawheed are determined by the
impact that an Islamic action leaves on the heart and soul of the
individual. A good action can certainly also be performed in any other
type of socioeconomic system, yet the significance of tawheed on the
individual and society is different. Humanistic social contracts such as
the laws of marriage, trade, inheritance, education and others, distri-
butional justice based on market or regulated economic systems, the
social relationships of consumption, production and exchange such as
those formulated by the utilitarians, the marginalists, Keynesian and
socialist thinkers, are of course all viable actions affecting human lives.
Yet in the eyes of shariah all these and the like are man-made laws and
therefore subject to the vagaries of individualistic subjectivity, ethics,
values and limitations. On the other hand, every Islamic action in
accordance to shariah must acknowledge the supreme reality of God as
the de jure and de facto ruler and guide over all human actions. This is a
bounden and immutable basis of the shariah. It cannot be allowed to be
transgressed by liberal human action. No man-made law, no matter how
well-intentioned, can become an Islamic action, accepted by the shariah,
if it overlooks or transgr-esses the limits prescribed by it. The shariah,
therefore, serves as the instrument to keep man in harmony with his
Creator through individualistic and societal actions. Through the 'inner
connection that the teachings ofthe shariah have to the spiritual life', a
Muslim transforms an otherwise secular act into an Islamic act. 9 This is
the idea of tawheed (unity) in the Islamic social context.
The social relations of welfare ordering in an Islamic system are
functions, not merely of purely economic variables, but includes non-
economic variables as well. However, through the laws of shariah the
non-economic forces impinge upon and in practically observable ways
augment the purely economic variables. The Islamic Divine Law is, of
course, comprised of two branches, ibadah, that which deals with
Islamic acts of worship, and mua'malat, that which deals with social
transactions. But in the eyes of shariah this is only a disciplinary division,

not a real one.
Tawheed along with another basic principle of Islam, namely Islamic
Brotherhood, constitutes the first basic principle of an Islamic economy.
The two are interlinked because they teach man how to relate and deal
with his fellow men in the light of his relationship with God. 10 In
practical terms the essence of tawheed and Brotherhood lies in equality
and co-operation. Freedom of choice, decision and private enterprise is
the inevitable consequence of the principle of tawheed and Brotherhood,
since this implies equality and co-operation and that man must be given
the opportunity and freedom to exploit the God-given resources for
productive purposes.
The above discussion suggests the central role played by shariah in
defining some key principles of Islamic welfare economics, namely the
principles of tawheed and Brotherhood. With this let us now return to
the social welfare function. With the basic welfare principle now defined,
we find that the shariah would be the main instrument of defining the
cardinal indicators of the social welfare function as well as the relations
among these cardinal indicators. The following economic conclusions
now come out of this: (i) that individual utility indices are important in
developing pre-ordering of preferences for consumption and social
states; (ii) that individual actions in this regard are limited to the extent
of conforming to the laws of shariah; (iii) that the progressive
assimilation of the laws of shariah in the lives of the individuals makes
social actions and preferences a fair reflection of individual preferences,
and this reduces the indeterminancy of the social welfare function;
(iv) that the determination of conditions for optimum social welfare
must now be carried out in a non-market environment also.
The Quantitative Aspect of Islamic Social Choice Function
In this chapter we shall limit ourselves to a simplified discussion of how

individual and social preferences are formed in an Islamic economy and
how it is possible to impute quantifiable values to the non-market
determinants of the social welfare function. We shall be working in a
highly abstracted form of the Islamic system characterised by its
economic and social values. These would be the values that create,
sustain and move the system, and are in turn generated, furthered and
established by the system. Therefore, our first task in this chapter is to
delineate clearly the economic and social values that create an Islamic
114 Microeconomics
system and the principles that sustain these economic and social values.
The overriding importance of shariah as the cohesive and substantive
force of an Islamic society suggests that primarily there must be an
Islamic state, having its own economic system and also a well-defined
social welfare function. The political, social and economic foundations
of such a state must be established on the basis of shariah. We have
mentioned earlier that the shariah contains the injunctions ofthe Divine
Will as they apply to all facets of life, private and public.
Politically, shariah establishes the belief that God is the only and sole
legislator for the Islamic state. Man has no power to make and legislate
laws. He abides by the law of God as embodied in Quran, developed
through the traditions of the Prophet Muhammad and the process of
ijtehad, meaning striving to extract the rules oflaw from its sources. The
head of an Islamic state is powerless to legislate laws. He only executes
the laws ofGod. 11 The function of the state is to use ways and means for
executing the Divine Laws with full force in all departments of life.
This point establishes the first assumption for Islamic preferences, i.e.
Islamic social preferences are unique and fully determinate in respect to
every effective application of shariah to the departments and functions
of the state. Note that this postulate of the Islamic social welfare
ordering is not at variant with what is known as Arrow's condition of
citizen's sovereignty,12 but the point warrants a closer look.
Let us make a comparative discussion of this Islamic social-ordering
postulate vis-a-vis Arrow's condition of citizen's sovereignty. Arrow's
condition states that the social welfare function cannot be imposed, i.e.
society must be left to choose only among all forms of admissible
alternatives and no other. The social welfare function then is defined
only for sets of individual ordering compatible with the desired
socioethical norm of the community. In an Islamic economy the
admissible individual preferences for social alternatives are formed
through ijtehad and ijma, meaning the consensus of the Islamic
community. The process of individual preference formation through
ijtehad involves the formation of individual opinion on the acceptance
or rejection of the findings of some authoritative Islamic policy. In the
absence of an Islamically conscious community the mujtahid, the person
exercising ijtehad, accepts or rejects the findings of ijtehad. In this way
either ijma or the established rulings of the mujtahid, represents an
Islamic social ordering. Note that in such a framework of determining
social preferences the possibility of a dictatorial form of social welfare
function is ruled out. While the Islamic social welfare function not being
of a dictatorial form is closer to Arrow's characterisation of the social
welfare function, it is also ditTerent from the latter in not being based on
consumer sovereignty, but rather on the constraints of shariah that bind
individual preferences to social ordering, selecting thereby, groups of
'admissible' individual preferences for the Islamic social welfare
function.
What immediately follows from this type of preference ordering is the
postulate that social choice by the Islamic state correctly represents
individual preferences. In an Islamic society, like in any other society,
this consistency of individual and social preferences involves a process
taking place over a long-run period.
Another major postulate of an Islamic social welfare function is that
of taqwa, meaning 'righteousness inspired by the fear of God',13 and
akhira, meaning 'knowledge of the Divine Judgement to follow after
life', are central arguments of the social welfare function, either
implicitly or explicitly. These two elements are fundamental to any
individual behaviour and also the basis for formulating any type of
social preference ordering.
The two elements induce two types of returns in the social welfare
function. On the one hand they define reward or penalty in the hereafter,
and on the other hand they playa determining role in the social relations
of production, consumption and exchange. The inclusion of the two
functionals in the social welfare function extends the time horizon to
after life, for the reward or penalty of an individual's actions in life
would be realised after life, and the knowledge of this transformation
brings felicity to the individual for being righteous, within his lifetime.
We are therefore, not looking at an intertemporal but rather at an
extended form of a social welfare function, whose intertemporal and
atemporal parts are intrinsically interconnected. Example of such
interconnected relationships are a Muslim's absention from the con-
sumption of haram, meaning 'prohibited food', and la israfmeaning
'controlled levels of consumption to avoid prodigality'. Both of these
actions signify worldly etTects on consumption, but the motivation to act
as such comes from the Muslim's belief founded on the Quran, that
abstention from haram and israf will bring him rewards after life.
The Islamic Social Welfare Function
The economic imponderables like taqwa and akhira can be treated

explicitly in a social welfare function, but the analysis that results from
such an approach has severe limitations of practical use. Zarqa,14 for
116 Microeconomics
example, develops an ordinal form of an Islamic social welfare function

including taqwa and akhira explicitly. He treats these elements as
atemporally affecting a Muslim's consumption behaviour through his
belief on rewards and penalty in the hereafter, depending upon the form
of consumption, obligatory or prohibited. The consumption function is
made a direct function of the rewards after life. It turns out that the
Islamic social welfare function developed by Zarqa is of little practical
use from empirical and economic viewpoints. It can be considered at
best as a normative framework of social behaviour in an Islamic system.
There is yet another approach to a social welfare function with
imponderables that one could consider. This is to develop a general
theory of social preferences based on the consumption theory of time
preferences. However, the conceptual problem with such an approach
would be the ordinal nature of the time-preference rates, resulting from
which, the social welfare function would be indeterminate and normat-
ive in analytical content. The indeterminacy of the social welfare
function contradicts one of the postulates of the Islamic social ordering
mentioned earlier.
In order to make an Islamic social welfare function practically useful
for policy formulation, we must think of a framework of analysis that
could impart quantifiable dimensions, measured intertemporally, and
resulting from the Muslim's belief, on rewards from the abstention of
haram and the practice of balanced consumption. A further use of this
approach would be in establishing social relations between production,
consumption and exchange, and the forms of ibadah, meaning 'wor-
ship', whose effects on the former would be measurable, within the
intertemporal horizon of economic activity.
Let us elaborate further on the above point by considering the
principle of la israfin an Islamic social welfare function. By applying the
principle of la israf to an Islamic intertemporal utility function, we
would expect that savings at an initial period of time would be weighted
more towards the production of capital goods rather than consumption
goods in the next and subsequent periods oftime. 1s This, however, does
not mean that we ignore the possibility of investment in consumer goods
altogether. The main point is that we put a constraint in the consump-
tion of luxury goods and also on an unrestricted amount of essential
consumer goods and services in future periods of time. These are
Islamically warranted.
The shift in emphasis from investment in the production of consumer
goods to capital goods implies that the notion of marginal rate of time
preference is replaced by the more realistic, better understood and easily
quantifiable quantity, the marginal efficiency of capital. However, now

that it is determined under an intertemporal consumption-investment
menu, it is an intertemporal rate. By the use of the marginal efficiency of
capital we approach to explain a theory of social time preference that is
not ordinal, like the one referred to earlier.
By confining the time horizon of an Islamic utility or welfare function
to a finite one and allowing the principle of la israf to do the work of
transforming atemporal Islamic returns to their intertemporal equi-
valents, a significant feat is accomplished. Resulting from this approach,
the Islamic social welfare function would be structurally well-defined,
empirically estimable and definite policy oriented. Such an approach, of
course, departs from the existing approaches to an Islamic social welfare
analysis mentioned earlier.
Going back to the history of utilitarianism one finds that the
scholastic doctors and the natural law philosophers deemed it necessary
for purposes of specifying an empirically viable and normative social
welfare function, to narrow down the immense range of variables and
attitudes explaining the pleasure and pain calculus of welfare econ-
omics. Schumpeter remarks on this point that, 'It should be
observed . . . that this individual self-interest was oriented on rational
expectation and individual pleasure and pain, which, in turn, be defined
in a narrowly hedonistic sense.... For if we go very far beyond the
grossest gratifications of the simplest appetites, we come dangerously
near to identifying expectation of "pleasure" with all possible motives
whatsoever, ... and then, of course, the doctrine becomes an empty
tautology'. 16
The Historical Context of Welfare Economic Thought in Islam
The methodological significance of reducing the elements of akira and

taqwa to a given set of measurable mundane equivalents is also to be
found in the economic thought of Ibn Taimiyya. For example, let us
look at Ibn Taimiyya's thought on the institution of al-Hisbah. AI-
Hisbah is defined by him as the control on an individual so as to observe
what is commonly known as good and to give up what is commonly
known as bad. 'This control is concerned with what does not fall under
the authorities of governors, judges, or other specified public responsi-
bility bearers.'17 AI-Hisbah provided the office of the muhtasib, the
man in charge of this institution, with the responsibility of controlling
the market-place. He also looked into matters of financial legislation,
118 Microeconomics
housing and purely religious matters too. Thus through the institution
of al-Hisbah an otherwise purely moral, ethical and religious basis of
Islam was transformed into practical mundane equivalents in the
economic life of the state.
In the matter of the welfare state Ibn Taimiyya held the view that
prophethood is necessary for economic matters, for it generates the
effects of truth, honesty, co-operation, sacrifice and moral values in
general on production, distribution and economic prosperity. 18 He said:
'Shariah is not meant to differentiate the useful and harmful objects by
means of senses. This is done even by the animals; they distinguish
between grain and clay. Shariah is meant to perceive those deeds that can
benefit or hurt man in his economic and other worldly matters; for
example, unity of God, justice, virtue, charity, good behavior and
fulfilment of rights.' 19
CONCLUSION
Social welfare in Islam is attained through ethical perfection, meaning

the rendering of the greatest good to the entire creation. The power of
the ethical perfection impinges upon the market-place and upon the
social relations of production, consumption and exchange. That ethical
perfection, known as ihsan, is an exogenous pivot of the Islamic welfare
state determining all aspects of the economy and much more. Llewellyn
defines ihsan as the 'greatest degree of moral righteousness, practical
benefit and aesthetic ancestry'. 20 The practical applications of ihsan is to
be found in explicit administrative spheres, and is enforced legally
through the duties of islah, meaning 'righteousness and benefits to
human societies through the exploitation and management of the
potential resources'.
Finally, in the practical sphere of economic accounting, when an
Islamic social welfare function is used for quantitative analysis, say
based on a cost-benefit model of the state applied to a given public
project the idea of costs must be one of total cost, i.e. the usual costs of
investment plus the outlays in zakah, meaning an Islamic religious tax
on wealth, taxes if any to an Islamic government, costs of running a
related al-Hisbah function, etc. This total cost is termed as mafasid. On
the other hand the 'total' benefit must be considered, i.e. the usual
benefits of investment returns plus the special benefits of zakah, returns
to al-Hisbah functions, the formation of public goods, better citizenship,
better conscious Muslims and a higher social order. The last three are
interrelated. This total benefit is termed as masalih. Thus, in the Islamic

framework, these ideas of the total good and the total use of resource
towards the achievement of that good, replace the limited ideas of costs
and benefits in secular economic analysis. 21 The ideas of masalih and
mafasid in tum affect production, consumption and exchange in an
Islamic economy.
The Islamic welfare economist must, therefore, be working in a
general equilibrium network of costs and benefits, establishing and
being established by the vigorous interaction of Islamic ethical, moral
and religious values with the media of production, consumption and
exchange. This general equilibrium network must have the singular
exogenous pivot, that unique sovereignty belongs to God, and man is
His vicegerent on earth entrusted with the conduct of the affairs of his
societies in accordance with His laws as embodied in Quran and Sunnah.
SUMMARY
The following are the postulates of a social ordering in an Islamic

welfare state, in addition to the well-known rationality axioms men-
tioned at the end of the chapter:
(1) Islamic social preferences are uniquely determined and fully
determinate in respect to every application of the shariah to specific
department and functions of the state.
(ii) An individual has a free choice of alternatives to the limit of
admissable alternatives. This bundle of admissable alternatives is
formed through the community's ijtehad and ijma.
(iii) A social ordering is established either through the collective
action of the community towards ijtehad, or through the ruling of the
mujtahid.
(iv) A corrollary of the above postulates follows: An Islamic social
ordering is a correct representation of collective individual preferences.
Therefore, an Islamic social welfare function is an ideal representation of
individual preferences.
(v) The elements of taqwa and akhira are the key variables of an
Islamic social welfare function. They primarily influence and are then
influenced by the social relations of production, consumption and
exchange in the milieu of general equilibrium analysis.
(vi) The elements of taqwa and akhira mayor may not appear
explicitly in an Islamic social welfare function. Where they do not
appear as such they implicitly impinge upon the social relations of
120 Microeconomics
production, consumption and exchange, producing measurable effects

on these relations, and which in tum denote the worldly equivalents of
the former elements.
Apart from the above postulates the following ones for a social
ordering would also apply:22
(I) If from a social standpoint situation X is preferred to situation Y,
then Y is not preferred to X.
(2) Iffrom a social standpoint X is preferred to Yand Y to Z, then X is
preferred to Z.
(3) If from a social viewpoint neither of X and Y is preferred to the
other, and again neither of Yand Z is preferred to the other, then
likewise neither of X and Z is preferred to the other.
These three postulates are sufficient to ensure that social preferences
establish a complete ordering among the possible social situations from
which the existence of a social welfare function at once follows.
Note, however, that although the second set of postulates fully
establish the existence of a social welfare function, there is a difference
between the 'subjective' preferences and individual 'ethical' preferences.
In the existing literature,23 'subjective' preferences underlie a truly
individual utility ordering, whereas, 'ethical' preferences are determined
by the preferences of other individuals in society. In an Islamic state the
two sorts of preferences would be the same up to a scalar transform-
ation. This follows directly from postulate (iv) and therefore from
(i)-(iii) of an Islamic social ordering.
Part III
Macroeconomics
The logical successor to Part II on Microeconomics is Part IlIon
Macroeconomics in the accepted dichotomy of mainstream economics.
Analysing and developing the Islamic macroeconomic system within this
accepted approach of mainstream economics, we explain the functions of many
of the islamic concepts, and legal as well as religio-socioeconomic instruments
introduced in the earlier sections. This part also follows the same accepted
sequence of chapters to be found in a static treatment of macroeconomic theory,
namely, investment theory, consumption theory and general equilibrium
analysis. These are then followed by some areas of applications of Islamic
socioeconomic principles. The following chapters are devoted to a development
and an analysis of the Islamic economic theory in these areas of
macroeconomics.
In Chapter 9 we introduce the theory of investment in Islamic perspective. The
main thrust of this Chapter is to first explain the comparative theories of interest
in neo-classical and Islamic thought. We then formulate a rational theory of
investment in the Islamic framework by replacing the rate of interest by the
normal rate of profit. Although investment theory in Islamic perspective is the
central focus of this chapter, we discuss also at a minimal length the Islamic
outlook on resource allocation between consumption and investment activities.
In Chapter lOwe introduce the theory of the consumption function in Islamic
perspective. Patterns of consumption behaviour in an Islamic society is
explained. A macroeconomic consumption function is developed from its
microeconomic roots, wherein the consumption function for the individual is
defined as one in personal consumption expenditure and a quasi-consumption
bundle explaining an individual's Islamic altruistic preferences. On the basis of
the macroeconomic consumption function certain implications on savings and
growth are empirically investigated.
In Chapter 11 we develop and analyse the general equilibrium macro-
economic system of the Islamic order. Normative as this system is, it is shown to
yield a uniquely determinable set of macroeconomic indicators for the Islamic
economy.
9 Investment Theory
in an Islamic Perspective*
INTRODUCTION
The issue of the existence of a positive rate of interest in models of

economic growth and resource allocation is highly debatable in the
economic literature. In the capitalistic system interest is the result of the
roundaboutness of the capitalistic mode of production. In order to
examine the theoretical constructs of the determination of the rate of
interest in such a system one can go to the works of Knight,l Lange, 2
Joan Robinson, 3 SrafTa4 and Dorfman, Samuelson and Solow. s In this
chapter we shall first make a brief study of these and other modem ideas
of interest and then place the pure Islamic theory of interest in sharp
contrast to these.
A CAPITALISTIC ECONOMIC IDEA OF INTEREST
The ideas on the theory of interest and capital put forward by Knight
and Lange are similar: The capitalistic mode of production uses two
types of labour, direct and indirect labour. The final product being a
commodity, there is labour which is expended directly in the production
of that commodity. On the other hand indirect labour is the labour used
in the production of certain equipment, which is used in the production
of the final product. The same idea can be applied to any factor of
production. Therefore, the final product in a capitalistic system is the
result of a combination of many intermediate goods each using its own
factor inputs, and by deduction, its own direct and indirect labour
inputs. The process goes on. Now the marginal productivity of both the
.. Originally published under the title, 'The Doctrine of Riba', in Journal of Development
Studies (Institute of Development Studies, NWFP Agricultural University, Peshawar, vol.
ii (1979)).
123
124 Macroeconomics
indirect and the direct factor in the final product can be measured only
when the latter is ready. Thus, the indirect factor, so to say, waits in time
to receive its rewards based on its marginal physical product of the final
good.
Knight and Lange now define interest as the difference between the
marginal productivity of indirect and direct factor of production in the
final product. The rate of interest is the ratio of this difference to the
marginal productivity of the direct factor in any two stages of
production. Then the amount of interest and the rate of interest so
defined are rationalised to cover the cost of waiting of the indirect factor
till the time the final product is ready.
By defining marginal net productivity of real capital as the difference
between the marginal productivity of real capital and its marginal cost,
the real rate of interest is defined by the above-mentioned authors as the
ratio of the marginal net productivity to the marginal cost. Thus, in a
capitalistic system there is a whole spectrum of rates of interest, nominal
or real, corresponding to the various indirect factors of production
distributed over time. The prevailing rate may be taken as some sort of
an average of these different rates, just like in the term structure of the
interest rates. 6
In the matter of the magnitude of the rate of interest, Knight is of the
opinion that it can never be zero, because the marginal productivity of
capital is never zero. However, Lange holds that the rate can be zero
even when the gross marginal productivity is non-zero, because the
marginal net productivity can be zero in a situation where the marginal
productivity of capital is equal in all possible uses. This depends
empirically on the shape and form of the production function, that is, on
the mode of production. One such possibility is when an increase in
capital in an indirect use must be taken away from the original stock of
capital available for direct factors of production, resulting thus in an
increase in the marginal productivity of direct labour and a decrease of
the same for indirect labour. Finally, we reach a point where the two
marginal productivities are equal, thus giving a zero marginal net
productivity offactors, and consequently, a zero amount of interest and
interest rate. In a capitalistic mode of production a zero rate of interest is
an accident of resource utilisation. A positive rate would almost always
exist, because in a roundaboutness of production techniques, the
overwhelming shift towards the production of consumption goods
makes capital goods to be produced in small amounts.
Joan Robinson's position on the rate of interest is based on her
critique of the neo-classical theory of interest and capital. She points out
that the neo-classical idea of marginal productivity oflabour as a return
Investment Theory in an Islamic Perspective 125
for labour time does not include the cost of capital, which is being used
by labour now, over the period from its make to the time it produces a
flow of returns. This is so, because in determining the marginal
productivity oflabour, the return to capital or else the capital stock itself
must be kept constant. 7 Now, the total cost of capital includes the cost of
capital goods, part of which is the interest as an opportunity cost over
the period of time between the first use of the capital goods and the flow
of returns over time. This cost of capital goods is not included in the
actual return to the entrepreneur. Therefore the neo-classical theory of
wages underestimates the actual return to the entrepreneur by the
interest cost on capital goods.
For this reason the neo-classical theory of interest and capital was
gradually being discredited over the idea of roundaboutness of the
capitalistic modes of production, first forwarded by the Austrian school
of economics 8 and later reformulated by SratTa,9 Garegnani,IO
Dorfman, Samuelson and SOlOW 11 and defended by Joan Robinson. 12
In this roundaboutness of the capitalistic mode of production interest
must enter the system as a price for waiting. This price for waiting
would, so to say, cover the cost of capital goods over the time it was
being produced to the time when it produces a flow of output.
SratTa explains the idea of roundaboutness of production techniques
in a capitalistic system and the existence of the interest rate, in terms of
dated quantities of labour. As in Knight and Lange's systems the final
product in Sraffa's system is produced by the use of various intermediate
commodities, each using its own labour inputs and other intermediate
commodities. The process goes on. There can in fact be an infinity of
such intermediate means of production of dated quantities oflabour and
commodities. Now, the production of the intermediate commodities
involves waiting time in the final production, and therefore the price for
this waiting to the capitalist is taken as the interest rate. Although SratTa
speaks in terms of the profit rate, this rate when equated to the price of
waiting is the same as an interest rate.
In SratTa's system there is not one, but a whole spectrum of interest
rates, each corresponding to a particular stage of production of
intermediate goods and dated labour. Unlike Lange,13 SratTa seems to
leave no provision for a zero rate of interest in the context of the
roundaboutness of production techniques, for there is no idea of net
productivity involved, and since each intermediate commodity pro-
duced has its own equation of dated quantities of labour and com-
modities, therefore, there would be at least one non-zero rate of interest
as defined in this system.
Dorfman, Samuelson and Solow have presented a model of the
126 Macroeconomics
roundaboutness of capitalistic technique of production, which is ofa

general nature. The models of Jevons, 14 Bohm-Bawerk, 15 Evans 16 and
Lange 17 are special cases of the model. In this general model, society
starts with an initial endowment of capital stock at a given time. The
stock of capital net of consumption at the given time is then transferred
to the subsequent period of time as an input to produce more goods and
consumption then, and the process repeats itselfintertemporally. Thus,
at each point of time, the capital and consumption goods existing then
are produced by similar ones at previous points of time, and themselves
they produce more goods and consumption at subsequent periods of
time. Corresponding to any such endowment in time there are a number
of alternative ways, represented by paths, for generating the next period
allocation of resources between capital goods and consumption goods.
Of course, not all such paths are desired. The desired one is that which
yields the most efficient allocation. In perfectly competitive market the
most efficient path of allocating resources would also yield the optimal
path of capital accumulation for a capitalistic economy. Such is again
the production milieu in a roundabout mode of production, characteris-
ing a capitalistic production system. The authors then show that the
capital stock can grow in such a system only by a factor that is a ratio of
the rent per period on the capital stock then existing, to the price per unit
of that stock of capital. Such a ratio represents a percentage of the
capital consumption between now and the next period of time, so as to
keep the capitalist's present stock of capital intact. Such a rate is, of
course, the rate of interest in an intertemporal allocation of resources to
capital and consumption goods. It stems from the basis of the
roundaboutness of production in a capitalistic system.
We can now summarise our observations on the existence of the rate
of interest in a capitalistic system as propounded by the neo-classical
and neo-neo-classical economists: The existence of the rate of interest in
a roundabout mode of production, initiated by the Austrian school, and
thereafter defended by Sraffa, Joan Robinson, Samuelson and others is
based on three fundamental claims - (i) that it provided for the
opportunity cost of allocating scarce resources among competing ends,
(ii) that it was a cost on delaying consumption from today to tomorrow,
(iii) that it was a subjective real cost for maintaining the present level of
felicity of the individual derived from the consumption of certain goods
and services, over time.
Through the rate of interest an individual in a capitalistic system is
looked at as an infinitely consuming, insatiated and impatient consumer
of goods and services. His interruption of this behavioural pattern
brings him pains of sacrifice, to which he subjectively imputes a value

known as interest rate, the price for waiting - waiting between the time a
capital goods is being produced to the time the labour expended on it
generates a future flow of goods and services, or waiting to consume
goods and services till tomorrow. The magnitude of the positivity of this
rate depends on what the neo-neo-classical economists call the real cost
of allocating scarce resources among competing ends intertemporally.
The rate of interest was no longer static. Time had a significant effect on
its magnitude. The longer the time involved in production the higher
would be the rate of interest, because the entrepreneur would impute a
higher marginal product to labour expended in a productive process
involving a longer period of time than to labour expended directly to
produce an immediate product. Also the price for waiting would be
higher for longer periods of production.
In the capitalistic framework of analysis the present therefore, was
more valuable than the future. Present goods available for consumption,
therefore, had a premium over future goods for consumption. Present
consumption and intertemporal satisfaction had to be made equivalent
to future consumption and satisfaction through the allowance of
interest on present goods received in the future. In other words, the
future was discounted to the present by the rate of interest. Such a
premium on goods, however, was totally subjective in nature. Through
such a nature of the rate of interest the capitalist could exact the price of
waiting and of impersonal sacrifice evoked by the subjective nature of
man.
In the modem theory of interest there is, however, one aspect of it that
needs a closer investigation. In the context of the Austrian idea of
interest, total amount in interest comprises what is called 'originary
interest' and the other component called 'contract or loan interest'. We
must distinguish between these two concepts. The idea of originary
interest is founded on the fact that the value of total output produced by
a given outlay is greater than the sum of costs incurred in the production,
and this occurs regularly. Thus, the excess value constitutes a certain
profit. This is called 'originary interest'.18 On the other hand, when the
capital owner does not himself take part in the production process, but
hands over his capital to another in return for a fixed compensation and
for temporary use of his capital, then the compensation is termed 'loan
interest'.
In the case of originary interest we note that sometimes the owner is
also a worker in the enterprise. In such a case, part of the proceeds net of
the costs of production is the owner's wage for the work performed.
128 Macroeconomics
Even if the owner does not productively participate as a labourer he

none the less contributes to the production process of the enterprise by
dint of his initiatives and business acumen and this, therefore, gives him
justification to the charge, as part of the profit accruing to him. The
problem of clearly identifying originary interest as a form of en-
trepreneurial wage has received controversial treatment by several
economists who argue that in the various theories of profit such a
distinction is not possible. 19
If, therefore, the originary interest is really a charge taken by the
entrepreneur for the services performed by him and his organisation,
then it is tantamount to simply a wage or a price for the services
performed. Anything over and above this price would be an excess taken
by the entrepreneur unproductively. This excess is equivalent to loan
interest.
Finally, we have the Keynesian stance on interest. In the Keynesian
economic system interest rate is determined as a monetary phenomenon,
by the interaction of the liquidity preference function on the demand
side and the supply function of money. 20 The rate of interest determined
by the demand side equals also the marginal efficiency of investment.
Note, therefore, that the marginal efficiency of capital equals not the
profit rate but rather the rate of interest.
In the Keynesian system the interest rate is also thought of appearing
in the investment and savings functions as an equilibrating variable.
That is, on the demand side in the expenditure sector an increase in
investment does not shift income by the amount required to equate
savings to investment. Rather, it is the dampening effect of the interest
rate or of the marginal efficiency of investment on investment itself, that
brings the latter down and establishes an equality between savings and
investment. 21
In empirical works on Keynesian investment and savings functions it
has been found that the level of investment is negatively related to the
interest rate,22 but a positive relation between interest rate and savings is
spurioUS. 23 This goes to indicate that investors may be least affected by
the time-preference theory of interest as it relates to savings. This is
particularly true when the bulk of corporate investment is financed by
retained earnings.
THE ISLAMIC IDEA ON INTEREST
In sharp contrast to the above viewpoints on interest we have the

categorical denial of interest in an Islamic economy. There are many
verses of Quran forbidding usury in all economic transactions.
Before we attempt a brief discussion of different viewpoints on the

Islamic stance on interest, let us define the Islamic equivalent ofthe word
'interest'. In the Islamic literature all forms of interest are referred to as
riba.
The Quranic concept of riba or interest is not limited to loan interest,
discussed earlier. Literally, riba means excess over and above a thing, be
it in money terms or in fungible form. When money is involved in
exchange, riba refers to the form of excess that was taken by the pre-
Islamic Arabs over and above the principal loaned out to another for a
period of time. 24 When fungible commodities are exchanged by weight
or measure, then there must be strict equality in such weight and
measure, and immediate delivery of both goods. However, if the
commodities are of different species, then equality is not insisted upon,
but delivery must be immediate. 25
Technically the word riba is used in the Islamic literature in reference
to the excess charged by pagan Arabs over the principal. It is, therefore,
also referred to as the riba ofjahilliyah, i.e. the interest as practised in the
pre-Islamic period. According to this custom a loan made to an
individual was subjected to a payment of a certain amount every month
over a fixed period of time. Then the principal was claimed along with
the interest after expiry of that period. But if in case the debtor was
unable to pay back an extension was granted to him by increasing the
rate of interest. Riba of all forms is strictly forbidden in Islam. However,
there are economic quantities which are theoretically and socially very
different from riba, but which give rise to acceptable accumulative
effects to capital. We shall look at this point below.
COMPARATIVE ISLAMIC VIEWS ON INTEREST
All Islamic schools of ijtehad, i.e. authoritative Islamic research based on

fundamental Islamic sources prohibit the use of interest in any economic
transaction. However, the Hanafite school of thought has difference of
opinion here.
According to the Hanafite school the riba rule may not be extended to
transactions between a Muslim and a non-Muslim (harbi) in a non-
Muslim country at war with the Muslim country (dar al-Harb). The
Muslim jurist, Abu Hanifa holds that riba transactions would be allowed
in this singular case. He remarks, that 'if a Muslim entered dar al-Harb
under aman (pledge of peace) there is no wrong if he takes their (harbis)
property with their consent, by any means, or he has taken it lawfully
without any deception and therefore, it is permissible to him.26
130 Macroeconomics
It would seem that the Hanafite idea on riba transactions in the above
case may have been influenced by the deduction that war makes many
unlawful things lawful, so that ifthe Muslims were to win a war then the
enemies' property becomes permissible to them. On the other hand if the
enemies win the war they take the booty. Abu Hanifa may be applying
the idea that there exists a constant state of war between the Muslim and
non-Muslim countries. But this principle does not hold today when there
is so much possibility for treaties and negotiations.
This idea of riba 'principle' can be found in the agreement concluded
between the Prophet Muhammad and the Jews of Khaybar. In ahadith
Khaybar 27 Imam Muslim quotes Ibn Umar as saying, 'When the
messenger of God was victorious over Khaybar, he wanted to evict the
Jews. They appealed to him to let them stay on the land provided they
work and get one-half of the crops. The Prophet said, 'We shall let you
do so as long as we wish'.2B
Obtaining of the half of the produce from the Jews of Khaybar
without return of labour was share-cropping as commonly understood,
but it was permitted as an exception when dealing with foreign residents
and communities.
Now let us tum to some of the modern Islamic viewpoints on riba.
Confronted by the seemingly convincing economic theories of the West
and the Muslim intellectuals' incapacity or lethargy to project the
parallel and powerful economic philosophy of Islam, many Muslim
scholars over the ages started to cast doubt and question on the Islamic
viewpoint on riba, i.e. usury or interest. In this category of scholars
one can identify two groups of scholars-the apologetics and the
sceptics.
Among the apologetics is Yusuf Ali, who, for example, remarks in his
commentary to a Quranic verse,29 that though 'Usury is condemned, to
the definition of usury there is room for difference of opinion. Hadhrat
'Umar, according to Ibn Kathir, felt some difficulty in the matter, as the
Apostle left this world before the details of the question were settled.
This was one of the three questions on which he wished he had more light
from the Apostle.... The definition (al-Riba) I would accept would be:
undue profit made, not in the way oflegitimate trade, out ofloans of gold
and silver, and necessary articles offood, such as wheat, barley, dates and
salt. . . . My definition would include profiteering of all kinds, but
exclude economic credit, the creature of modem banking and finance:
Among the sceptics are notable Muslim economics, trained in modem
economics, who try to rationalise, through the arguments of modem
economic theories, that some form of interest on capital transactions,
real or nominal, cannot be avoided. Some of the scholars who belong to

this group are Syed Ahmad,30 Mannan 31 and Naqvi.32
Syed Ahmad, in his paper, raises a question on the definition of riba.
He holds the view that, 'it is the net rather than the gross return and it is
the real rather than the nominal rate the constancy and risklessness of
which is the necessary condition for Riba'. Then, he concludes, of the
four categories of interest rates, (i) gross and nominal, (ii) gross and real,
(iii) net and nominal, and (iv) net and real, it is only the constancy and
positivity of the last category that qualifies as riba. The arguments in
favour of such a conclusion is based totally on the functioning of a
capitalistic form of a monetary system with inflation. The paper takes no
account of the assumptions, characteristics and functioning of an Islamic
economic system, either in its true or transitional form, when the
preconditions of a final Islamic economic state are being shaped. Under
the latter type of system the conclusions of Syed Ahmad are no longer
valid.
At the least Syed Ahmad's analysis of the interest rates should have
been conditioned by a treatment of risk in a mudarabah partnership,
which is a profit-loss-sharing system of an Islamic economy, and also by
the nature of inflation in an Islamic economy in the absence of the
present-day bond market, accelerated consumer demand, and of the
nature of investment flow as opposed to excessive cash balances in an
Islamic economy. These considerations would clearly annul many of the
arguments and conclusions put forward by Syed Ahmad and similar
Muslim economists on riba.
Mannan remarks in his book that it is usury not interest which comes
closer to the idea of riba as mentioned in Quran, because both usury and
riba denote large excesses. However, interest according to him may
denote a reasonable excess. Therefore, according to Mannan the
difference between riba and interest is one of degree not of kind. Such an
approach to an analysis of riba and modern interest is not helpful in
explaining the nature of modern interest and the economic reasons for its
prohibition in an Islamic system.
Naqvi argues in his paper that for a capital scarce economy in
transition to an Islamic economy, the rate of interest must not be
abolished. Rather, he maintains that if the interest rate is abolished in a
transitional phase of the economy it will cause incalculable harm to the
economy. The rate of interest during the transitional phase of the
economy, Naqvi argues, performs certain 'desirable functions', which it
would not be able to achieve in the absence of that rate, namely, (i) that in
a static equilibrium the interest rate would be required to allocate scarce
132 Macroeconomics
resources optimally among various sectors of the economy; (ii) in a

dynamic economy a positive interest rate is desired to account for the
positive rate of social time preference, for covering the social cost of
capital consumption and for making up for the declining real value of
savings over time.
CASE AGAINST INTEREST AND THE ISLAMIC

ALTERNATIVE
Market economy justifies interest because it makes an initial outlay of

capital to become a continuous supply of capital, which in turn would
promote the production process. This indeed would be acceptable if
interest was in fact related to the actual proceeds from production, and in
which case this interest rate would become analogous to the growth rate
of output. 33 However, in reality the rate is fixed at a given level
irrespective of what the actual proceeds and the actual income may be. As
a result, interest rate puts a limit to the marginal efficiency of capital.
When the marginal efficiency of capital is reduced, it leaves several inputs
unemployed. This underemployment of resources lowers the rate of
production, so that to maintain the profit level, firms will have to sell
their outputs at higher prices, and maintain the labour force at lower
wages or cause unemployment. All these can be proven more formerly.34
Let x denote the gross output of capital goods
p = p(x) with p'(x) > 0 denotes its supply function,
where Xo is the replacement demand for x,
k is the given stock of capital,
i is the investment level.
Then the marginal units of capital goods acquired have the stream of
net returns a", (t), 0 < t < T.
Now p = V(a""r",) = f:a",(t)e-r.tdt,
where V denotes the present value of the stream of future yields. The
marginal efficiency of capital r", is given uniquely in terms of i, such that
r", = r",(i), where r;"(i) < O.
Furthermore i = i (r "'), where i' (r "') < O.
If r is now taken as the market rate of interest, the above relations hold.
In general
i = i(r, K), with ai/or < 0, ai/oK < O.
This proves what we stated above, that investment and, therefore,
productive activity in the economy declines with the increase in the
interest rate, and the stock of capital which is functionally related to the
interest rate through the investment schedule also declines.
Next consider the question of the demand for labour. Let the
production function be y = y(n), with y' (n) > 0, where ydenotes the real
output, and n is the employment. Taking the output price as P, under
perfect competion we will have w = Py' (n), i(r) = s(y(n)), where w is the
real wage rate, s is the level of savings.
y'(n) > 0, y"(n) < O. Take P = 1.
On differentiating the investment-savings relationship given above we
obtain,
dr/dM = (a' y'/i')(dn/dM),
which is a negative multiple of dn/dM. Hence, dr/dn < O. That is, as the
rate of interest rises employment falls, as stated above. In the above
expression, M denotes the stock of money.
If there was no interest the purchasing power of money would be used
either in consumption or in investment, directly through banks function-
ing on the principle of profit- and risk-sharing in the actual returns from
investment. This principle is known as mudarabah in Islamic economics.
We argued earlier that tn such a case the market rate of interest when it is
not fixed, i.e. not exogeneously determined, is equatable to the growth
rate of dividends. Thus consumption activity will encourage production,
while investment activity will provide capital for further productive
processes. In either ways production increases, so that employment also
increases along with it.
In this regard the Fisherian analysis 3S of capital markets explaining
the role of productive investment and financial transactions is well
known. The mechanics of consumption-investment allocation of re-
sources can be explained in Figure 9.1.
Let QSQ' denote the productive transformation curve, and QM
denote an initial capital constraint indicating that an individual's
resources are underutilised in a framework of optimal investment
possibility. Now the individual can borrow or lend as much as he wants
by moving along QM, but this does not increase his wealth. Hence,
financial transactions cannot increase an individual's wealth. On the
134 Macroeconomics
c~
FIGURE 9.1 Optimal allocation of investment in an Islamic economy

inter temporally
other hand, if the individual invests till at an optimum point S, his wealth
is given by R T, which corresponds to his returns, and the return on the
marginal productivity of capital corresponds to ST.
In the Islamic economy the above mechanics of consumption-
investment allocation of resources is similar. However, first, the quantity
ST would now correspond to a return on the profit rate. Second, it is
important to note how the budget line QM shifts to CoC 1 and what then
would be the resulting shape of the locus of optimal investment
possibilities given by points like S on the production possibility frontiers
corresponding to new thresholds of investment.
This analysis of shifting capital constraint lines and of the locus of
optimal points like S is founded on the Islamic idea of intertemporal
allocation of resources in consumption and real investment. 36 This is
explained below.
The Islamic idea of intertemporal consumption-investment decision
is opposed to the very basis of the modern intertemporal allocation of
income biased towards consumption as given by the consumption theory

of interest. In an Islamic economy such an approach to intertemporal
allocative decision is replaced by the idea of individual and social felicity
obtained through allocation of income predominantly into real invest-
ment intertemporally. The rationale for this new choice-theoretic
approach is explained in the Islamic economy on the basis of the
following consumption-investment constraints:
(i) The Islamic society gives consumption priorities to the necessaries
and comforts ofHfe in this order. It is widely agreed upon by many
Islamic scholars that the production and consumption ofluxuries is
prohibited. 37
recommended, for this creates wastage of factors of production and
of produced goods. 38
and comforts of life and more capital goods that increase the
productive capacities in the following periods of time is highly
encouraged. Such is indeed the way how production, growth and
development proceed intertemporally.39
The above constraints in an Islamic consumption behaviour brings
out some immediate results on the intertemporal allocation of income in
an Islamic society. Socially, savings in the form of real investment would
generate social returns through production, lower prices and lower
unemployment rates. The production can be of consumption goods,
meeting the necessaries and basic comforts of life, and of capital goods
that carryon the productive capacity into future periods of time.
Privately, savings in the form of real investment would protect the
individual from paying zakah on savings in cash balances. Thus, the
distributional and growth effects of zakah are passed on to society
through the returns from investment.
Therefore, in the Islamic economy the choice to the individual is not
between today's and tomorrow's consumption, but rather between
today's investment returns and tomorrow's investment returns. This is
the same thing as lagged investment intertemporally considered. Private
and social rates of time preference as explained by the consumption basis
of interest are, therefore, untenable in the Islamic economy. They are
replaced by the marginal efficiencies of capital, privately owned or
socially owned, as the case may be.
Because of the consumptional constraints in an Islamic economy, the
long run pattern of consumption-investment allocation of income puts a
136 Macroeconomics
higher weight on the marginal efficiency of capital investment, as

opposed to consumption goods investment. This is so, because after
satisfying the essentials of life, comforts and spending on others through
Islamic channels, the net income, no matter how large cannot be spent in
exorbitance. 40 The Islamic individual, therefore, has a satiation point on
his indifference contours in the consumption-investment plane with
respect to consumption, unlike the modem economic consumer, who has
no such point in the intertemporal consumption plane.
Let us analyse the above points more formally. It is known that
present investment returns would depend on previous investment. In a
one-period lagged model we would have
y, = rxl, -1 +fJ
where Y, denotes returns at time t from investment at time t - 1,
/ - 1
'
denotes investment at time t - 1,
rx, fJ are constants.
Absolute differences in the levels of Y, and / ' - 1 are related by,
AY, = A/, - 1·
Likewise AY,+1 = Alt·
Therefore AY,+1 = AY, = A/I /A/, - 1·
Clearly, money available today for investment is more desired than
money available tomorrow for investment. Therefore,
AY,+1/AY, =- (1 +r),
where - (1 + r) is the slope of the income line at the point oftangency of
this line with the investment possibility curve. Since r is directly related to
investment, so it is in fact the marginal efficiency of investment.
Because r is inversely related to the investment level, therefore, as
investment increases in the future due to the transfers of funds from
potential consumption to investment, it is made more and more
attractive by a declining r. The capital or returns-line, QM, now shifts
upwards to CoC l ' Future investments bring higher prospects of returns,
part of which he can consume on necessaries and comforts, and the rest
he can invest. Therefore the individual, limited by his consumptional
expenditure today, acts rationally by increasingly investing the available
resources into real investment over time. The optimal locus of points of
tangency of the capital constraint with the investment possibility curve,
like S, thus shifts upwards, as shown in Figure 9.1.
We have so far discussed the first part of the concept of riba from an
Islamic point ofview, namely, that it is an excess over and above the value
of a fungible commodity in exchange for another fungible commodity,
expressed in weight or measure. We now turn to the second part of the
Islamic concept of riba.
The second part of this concept necessitates an immediate delivery of
goods loaned and borrowed. This is analogous to the idea of time
preference for money, i.e. a dollar received today is worth more than a
dollar received later on. As a result the individual's utility for that dollar
diminishes by postponement in payment. Postponing payment of a sum,
therefore, subjects it to a discount rate. But this discount rate cannot be
taken as a subjective rate of time-preference or as an interest rate. It is
instead the marginal efficiency of capital in the intertemporal framework
of investment discussed earlier. It is now not a pre-fixed rate as in the case
of the loan interest rate, but is determined only after we have determined
the actual total returns from investment or financial transaction as a
profit-sharing rate. 41
The final and an important distinction made by the Quran is between
interest and trade. Let us now look at the Islamic viewpoint on trade and
interest. The Quran states that ' ... God has allowed trade and has
forbidden Riba'.42 In trade the private entrepreneur is exposed to loss as
well as to profit in his enterprise, but in lending (borrowing) money with
interest, the whole of the loss is suffered by the man who uses labour,
while the entrepreneur can count on an excess in returns, even in the case
of actual loss. Therefore, in the conflict between labour and capital, Islam
sides with labour in that if there is loss (profit) in an enterprise, it has to
be shared equally by both the labourer and the capitalist.43
In the sphere of commerce Islamic banking operates on the principle
of shirkah i.e. co-operation. Capital requirements of a modern Islamic
state can be secured by borrowing money on the basis of sharing the
profits arising from its productive usage. Other financial intermediaries
in an Islamic system can be made to function on the same principle of
shirkah or co-operation.
In the light of the above two paragraphs we notice that an Islamic
economy by virtue of strongly recommending trade that is interest-free,
would stand for a system of free enterprise. At the same time, while an
Islamic economy prohibits interest-based transactions, it proves to be
forerunner of a socialistic mode of resource management. In this sense,
therefore, the Islamic economy is midway between the capitalist and
socialist systems. While an Islamic economy allows free trade,
enterprise and profits, these cannot be obtained through the medium of
138 Macroeconomics
interest, sharecropping, profiteering, monopoly, exploitation and such-

like economic activities which cause hoarding and reduce productive
investment. By using the rate of profit as the rate of capitalisation in
valuation models,44 instead of the marginal efficiency of investment
equated to the rate of interest on the demand side ofliquidity preference
as in the Keynesian system, it logically evades the objections raised by
Marx and Keynes on the profit concept which according to the former
leads to a contradiction between 'the forces of production and the
relationship of production'.45 The contradiction referred to therein is
essentially based on the idea of the surplus value, which is the profit
accruing to the capitalist through interest and accumulation of initial
capital. Marx, therefore, remarks that as capital increases the rate of
profit, i.e. the ratio of the surplus value to the total of wage bill and
capital depreciation charges, will fall. Keynes conclusion depends on his
notion of the marginal efficiency of capital. As investment increases, the
marginal efficiency of capital decreases and conversely, due to the fact
that prospective yield falls as the supply price of capital rises.
In an interest-free economy the marginal efficiency of capital depends
on the pure rate of profit. There is a constant tendency to decumulate
capital from the hands of the capitalists while at the same time there is a
continued encouragement towards productive investment.
CONCLUSION
We have tried to rationalize in this chapter the existence of a zero rate of

interest in an intertemporal allocation of resources between consump-
tion and investment and showed how in an Islamic economy a positive
rate of interest is replaced by a rate of profit or the profit-sharing rate.
The Islamic intertemporal allocation of resources between consumption
and investment is shown to be predominantly biased towards investment
in real capital. The consumption side is shown to be constrained by the
principle of moderate and permissible type of consumption of goods and
services. Therefore, in such an intertemporal framework the profit rate
would also be equitable to the marginal efficiency of capital.
The other aspect of the doctrine of riba is shown to be founded on a
notion of the time-preference for money. However, the time-preference
here is with respect to investment choices over time, and not in respect to
consumption theory of interest.
Because the discount rate in valuation models in an Islamic economy
would be the profit rate or the marginal efficiency of investment
intertemporally considered, therefore, it is understandable why in this

economy trade is highly encouraged and riba is altogether forbidden.
The same discount rate is also taken as a profit-sharing rate in mudarabah
business in an Islamic economy. In this case the profit-sharing rate is
really a weighted form of the profit rate.
10 Macro Consumption
Function in an
Islamic Framework
M. Fahim Khan*
INTRODUCTION
Consumer behaviour, i.e. how the consumers allocate their income

between different heads and how they decide how much to consume now
and how much to save for the future, is a key topic in modern economic
theory. The study of consumer behaviour has implications for macroeco-
nomic policies. Many modern economic theories conclude that savings
are essential for economic growth. The more people save in a country the
more rapidly it will grow. With this background, modern economists
conclude that the level of savings in an Islamic economy will be lower if
people have to pay zakah on their savings. While presenting this
argument, these modern economists consider zakah as a tax on savings
that switches allocation of resources from savings (i.e. future consump-
tion) to present consumption. Also, if we take part of the savings of the
rich and give it to the poor, who will obviously consume it all, aggregate
savings level in the economy, ceteris paribus, will naturally decline. The
conclusion, therefore, follows that Islamisation of an economy as it will
result in lesser savings will adversely affect its growth.
Are savings really essential for economic growth? Only those will
answer yes to this question who believe that capital accumulation is the
* M. Fahim Khan is Professor of Economics at the International Institute of Islamic

Economics, Islamic University, Islamabad, presently working at the International Centre
for Research in Islamic Economics, King Abdulaziz University, Jeddah, Saudi Arabia.
This chapter is extracted, with the permission of the author, from the Journal of
Research in Islamic Economics, vol. 1, no. 2 (1984).
140
Macro Consumption Function in an Islamic Framework 141
engine of growth. Some economists, particularly Islamic economists 1

may not believe so. We will, however, keep this question aside. Within the
popular view that savings are essential for economic growth, we will raise
only the following question: 'Is it really true that savings in an Islamic
economy will be lower than if the same economy was operating on a non-
Islamic basis?'
Our answer to this is no. We have developed two arguments to
support this answer. One argument describes the Islamic premisses
within which a Muslim will determine his consumption. It is argued that
these premisses are such that the aggregate consumption level will be
lower than if the Muslim were consuming under un-Islamic premisses.
The second argument is built upon the basis of a macroeconomic model
that includes the dynamic effect of zakah in an Islamic economy.
Through this model it is shown that even if there is any chance of a short-
run decline in the aggregate savings level due to the Islamisation of the
economy (i.e. imposition of such injunctions as zakah), this adverse effect
will soon be wiped out and the long-term savings and growth path will be
higher than if it were a non-Islamic economy. This results from the
income-distribution effects of zakah which causes the poor to ultimately
enter into the group of savers as their economic conditions improve.
Section I builds up the first argument, i.e. of the Islamic premisses
within which consumption of Muslims will be determined. Sections II
and III give a macro model for an Islamic economy. Section IV derives
mathematical comparison of savings propensities between Islamic and
non-Islamic economies. The numerical results of simulation under
various parameteric assumptions and policy conclusions therefrom have
been left for a later exercise.
ISLAMIC PREMISSES WITHIN WHICH A.. MUSLIM'S

CONSUMER BEHAVIOUR IS DETERMINED
Before I explain the Islamic premisses within which consumer behaviour

is determined, I will briefly describe the premisses within which modem
economists believe that a consumer decides his consumption pattern.
Modem economic theory studies consumer behaviour under the
following premisses.
(i) It is assumed that a consumer will decide what to consume and how
much to consume only to gain the material benefits and satisfaction.
(ii) It is generally assumed that all his consumption is geared to satisfy
his own needs. He is not bothered to satisfy anyone else's needs.
142 Macroeconomics
(iii) It is assumed that a consumer behaves rationally. This, among other

things, means:
(a) the consumer will neither be a miser nor an unnecessarily
spendthrift.
(b) he will not hoard his wealth.
Within these premisses modem economists then explain what and
how much a consumer will consume and how much he will save to invest
for future earnings consumption. These premisses are described as
axioms, i.e. they are assumed to be given in human nature. In other
words, no logic is given to explain why a consumer would operate under
these premisses.
It can easily be imagined that these consumption premisses can be
valid only if a consumer has been brought up in a particular cultural
environment and has been taught a particular philosophy of life. This
may not be true for all societies in the world. In fact very few societies in
the world may have such a cultural environment or such a philosophy of
life. Take, for example, the assumption of rationality. The type of
rationality that is required by modem economic theory is something that
may not exist in many societies due to their particular ethical, social and
cultural norms and customs. For example, who can stop an individual
from spending for other than worldly gains? (even in Western materialis-
tic societies people like to spend for non-material gains). Or, who can
stop an individual from spending for not his own but other's material
welfare also (the social and cultural structure of societies like India and
Pakistan and many other developing countries necessitates such spend-
ing by the individuals which are meant to satisfy not their own needs but
others' need as well?). Or who can stop an individual from becoming
unnecessarily spendthrift (a problem of many Western societies) or from
hoarding his wealth (a problem of many underdeveloped societies)?
Islam, having its own distinct ethical, sociological and cultural
framework provides completely different premisses for analysis of
consumer behaviour. The analysis of consumer behaviour under these
premisses will obviously be different from the theories that secular
economists propound.
A Muslim consumer in an Islamic economy is supposed to make two
types of spending. 2
(a) To meet his (or his family's) material needs (let us denote this type
of spending by El).
(b) To meet the need of others (for the sake of Allah) (let us denote
this by E2).
The total spending E, therefore, can be written as
E = E1 +E2
It is left to human discretion to allocate income between these two
types of spending. Human behaviour, however, is guided behaviour for a
Muslim-a person who is advised to be God-conscious or Godfearing.
Thus allocation between El and E2 will be determined by
(i) some of the parameters that determine the consumption pattern

of a rational consumer (as outlined by economics), and
(ii) degree of Godfearingness or God-consciousness (taqwa).
The role of Godfearingness in the spending of Muslims is clear from

various verses of the Quran.
Muslims are required to be God-conscious (God-fearing)
o Ye who believe; Fear Allah as He should be feared 3:102
The more a person is Godfearing, i.e. God-conscious, the better
Muslim he is
Verily the most honoured of you in the sight of Allah is (he who is)
the most righteous of you. 49:13
Who are the God-conscious? One of the definitions is those
ltho believe in the unseen, are steadfast in prayer and spend out of
what we have provided for them. 2:3
Thus, to spend in the way of Allah is one of the requirements for a
good Muslim.
The Quran does not exactly specify how much a person should spend
in the way of Allah. At two places the Quran answered the question
(posed by the companions of Prophet) what should they (Muslims)
spend, (2:215, 2:219).
At one place the answer was simply Say AI-'AfW' (2:219) That is one
should spend what is left over after meeting ones needs. At another place
the same question was answered as
They ask thee what they should spend (in Charity). Say: lthatever
ye spend that is good; is for parents and kindred and orphans and
those in want and for wayfarers. And whatever Ye do that is
good - Allah knoweth it well. 2:215
[(It is reported that this refers to the following question from the
companions of Prophet (peace be upon him). What should we spend
from our wealth and where should we spend it).]
Again the emphasis in the answer has been laid on where money
should be spent; for parents, relatives, needy and wayfarers. The answer
to how much should be spent has again been left unspecified by saying
144 Macroeconomics
And whatever Ye do that is good - Allah knoweth it well. 2:215

i.e. there is no upper limit. 'Whatever you can afford you should spend' is
the guidance. 3
Without specifying how much of one's income should be spent for

others in the way of Allah, great emphasis has been placed on such
spendings. The more one spends for others (for the sake of Allah) the
better for him in this world and the hereafter. This emphasis is apparent
from many verses from the Quran.
And spend of your substance in the cause of Allah and make not
your own hands contribute to your destruction; But do good. For
Allah loveth those who do good. 2:195
The reference of some other verses emphasising the same are (2:177);
(4:92); (9:34); (2:254); (2:262); (2:245); (8:60).
This spending in the way of Allah is entirely different from the first
type of spending (E d which is for worldly needs. From the second type of
spending, no worldly advantage is intended to be obtained. It has to be
for the sake of Allah with no worldly motives at all as is apparent from
several verses. For example
o Ye who believe; cancel not your charity by reminders of your
generosity or by injury-like those who spend their substance to be
seen ofmen, but believe neither in Allah nor in the last day. They are
in parable like a hard barren rock on which is a little soil; on it falls
heavy rain, which leaves it Uust) a bare stone. They will be able to do
nothing with what they have earned. And Allah guideth not those
who reject faith. 2:264
The same sense is repeated in verse (4:38)
Thus the second type of spending (E z) is entirely different from the
first type of spending (E 1 ).
Though no exact amount or any upper limit has been specified in the
Quran or Sunnah for the E z (or for E 1 ) we do find that there is a lower
limit for the amount of E z to be spent by those who are eligible. This
lower limit is the amount of zakah which is mandatory. But this is only a
minimum. To acquire a higher degree of Islamic credit a Muslim has to
make as much Ez-type spending as possible (see the Quran 2:3, quoted
above).
The stress on E z should not be taken to assume that El is less
important. We find specific guidance in the Quran and Sunnah,
emphasising the importance of E 1 (e.g. the Quran 7:32).
All good things ofthis world have been created for man. Muslims are
not asked to abstain from them. The Prophet (Peace be upon him) says
that when Allah bestows good things of the world upon one of His
servants He likes to see them retTected in his appearance (of course
without any intention of personal pride). The Prophet (Peace be upon
him) is also reported to have objected to the act of abstention from the
lawful enjoyment of material things. He is also reported as saying: 'You
don't really possess of your wealth but only what you eat and use up,
what you dress and wear up or what you spend on charity and preserve
(for the life hereafter).' At another place in the Quran we find
Eat of their fruits in their season, but render the dues that are
proper on the day that the harvest is gathered. But waste not by
excess: for Allah loveth not the wasters. 6:141
Of the cattle are some for burden and some for meat: Eat what Allah
hath provided for you, and follow not the footsteps of Satan: For he
is to you an avowed enemy. 6:142
Here, Allah gives two commands: One is to spend for one's own needs
and the other is to spend for others in the way of Allah. The command
'waste not' refers to rationality in both types of consumption. Some
other verses stressing Ertype spending are (7:31) and (2:168).
Another aspect of a Muslim consumer behaviour is that he has to be
rational in all his spending. This point of rationality is something that is
unique to the Islamic economic system. The theory of consumer
behaviour of secular economics assumes a rational consumer who takes
rational decisions. But how would rationality practically be achieved in
an economy? Secular economics by-passes this question and that is why
its theories lose practical relevance for most of the societies. Secular
economists treat rationality as an axiom relating to human behaviour,
whereas the type of rationality that is assumed by them is something that
would require 'proper' education. Developing or applying economic
theories without imparting this 'proper' education will simply be an
exercise in futility.
The axiom of rationality required for Islamic economic theories of
consumer behaviour is not simply an assumption which mayor may not
be true. It is something that a Muslim has to learn and acquire. Islam
teaches rationality with the same emphasis with which it teaches how to
spend and where to spend. The verse (6:141) quoted above indicates the
emphasis on rationality in spending. The same point is made in the
verse
Make not thy hand tied (like niggard's) to thy neck, nor stretch it
forth to its utmost reach; So that you become blameworthy and
destitute. 17:29
This lesson of rationality in spending is not only for worldly spending
146 Macroeconomics
(E 1 ), but is also for the spending in the way of Allah (E 2 ) as is clear from
the following verses
And render to the kindred their due rights, as (also) to those in want,
and to the wayfarer: But squander not (your wealth) in the manner
of spendthrift. 17:26
Those who, when they spend, are not extravagant and not niggardly,
but hold a just (balance) between those (extremes). 25:67
In all the commands that allow E 1, the only limit that has been
imposed is that 'do not consume prohibited goods and consume only
permitted goods'. This reduces, ceteris paribus, the consumption basket
of a Muslim consumer compared to a secular consumer (the possibility
of a larger basket as a Muslim though exists but is not likely to be true in
general).
So far nothing has been said about saving for future consumption or
investment to improve the quality oflife in future. This is actually a part
of E 1 type of spendings. It is a legitimate spending in Islam. There is
evidence available from the Quran and Sunnah that justifies
savings and investment.
To those weak ofunderstanding make not over your property, which
Allah hath made a means of support for you. 4:5
In the explanation of this verse, commentators state that wealth is the
capital of life and its preservation by rational spending is obligatory on
Muslims. The Prophet (peace be upon him) is reported to have said that
poverty is likely to lead to disbelief. This implies that Muslims should try
to improve their economic condition. This, in turn, justifies investment
and hence savings. A saying of the Prophet (peace be upon him) that to
leave one's inheritors better ofT is desirable compared to leaving them
poor also signifies the importance of savings.
Unlike the secular economic system that does not penalise hoardings
(savings that are not invested) Islamic economic system puts a specific
penalty in the form of zakah on hoarding that will ultimately eat up all
savings if they are not productively used to yield at least a 2t
per cent
return per annum. Thus a Muslim has the following options with respect
to this savings:
2t
(a) Hoard it and pay at least per cent of it every year in the way of
Allah.
(b) Lend it as Qard-i-Hasan (loan without interest) and earn reward in
the world hereafter.
(c) Invest it to earn at least 2t
per cent return per year.
A rational consumer, obviously, has no alternative but not to hoard all

his savings. If he decides to be irrational he will ultimately lose all that he
hoarded. Thus, savings have to be canalized towards investment. This
property ofIslamic economic system also reduces the chances of planned
investment lagging behind or ahead of savings, to create deflationary or
inflationary pressures, in the Keynesian framework. 4 A Muslim will try
to make investment with the following motives:
(a) to acquire permissible comforts of this world,
(b) to be able to have more to spend in the way of Allah and more
reward in the hereafter.
To recapitulate, the main elements of a Muslim consumer behaviour
are:
1. A Muslim consumer's total spending can be classified into the
following major categories:
(a) Spending to achieve satisfaction in this world (E 1 ). This includes:
(i) Present (immediate) consumption (let us denote it by Cd.
(ii) Savings investment for consumption in future (let us denote it
by SI).
(b) Spending for others with a view to earn reward in the hereafter
(E 2 ). This includes:
(i) What is immediately consumed by the recipients (let this be

C 2 )·
(ii) What is invested for social purposes or community benefits or
what is saved by the recipients for their own investment (S2)'
2. The consumption basket ofa Muslim is likely to be smaller than that
of a secular consumer as it includes only permissible things and
excludes prohibited things.
3. The allocation between Eland E2 and between C 1 and S I within E 1 or
between C 2 and S2 within E2 has been left to rational consumer
behaviour which should be dominated by Godfearingness.
4. The degree of Godfearingness is an essential parameter in determin-
ing consumer behaviour of a Muslim.
5. The only limit that has been specified is the minimum limit of E 2 for
those who are obliged to make these types of spendings.
6. A Muslim is allowed to save, a major part of which will have to be
invested in order to earn at least a return that would prevent his
savings from being depleted by zakah.
148 Macroeconomics
With the description of these premisses, it is not very difficult to see

that an Islamic economy will have a lower consumption propensity than
if it were a secular economy. The most important basis for this argument
is:
(a) that Islamic consumer is likely to face a smaller basket of
consumption to pick up from than if he were a secular consumer.
(b) from within this basket he has to pick without crossing the limits
of prodigality.
This is an immediate perspective. In a longer-term perspective we can
visualize that the spending that is done for the others will help the
'others' to improve their economic condition. Islam does not encourage
people to keep receiving zakah. They have to improve themselves to
come into the zakah-payers' category or at least in the not-zakah-receiver
category.
Able-bodied poor people are allowed to receive zakah only as a
stopgap arrangement to find an opportunity for them to improve their
economic condition. In a dynamic economy these people who are
presently poor and cannot save anything are likely to be able to save as
zakah helps them to improve their economic status. Thus even if in the
short run there is any reason to believe that savings propensity and hence
economic growth in the economy are likely to be lower, there is no reason
to believe that it will be so in the long run. This argument is further
developed in the framework of a macro model discussed in the next
section.
DERIVING CONSUMPTION FUNCTION FOR AN ISLAMIC

ECONOMY
A. Micro Consumption Function
Consumer derives utility from both types of spending El and E 2 • We

may write the utility function as
U = F(E l , E2 )
With the income constraint Y = El + E 2 •
This utility function has the following properties.
au > 0 i.e. marginal utility of E 1 is positive.
F1 = -
oE l
OFI
F1 = - < 0 i.e. marginal utility of El goes on declining as its
OEI
volume is increased.
au = a > 0 and·IS a constant.

F 2 = -;--
vE 2
This implies that the marginal utility of E 2 is a positive constant for an
individual with a specific level of God-consciousness. A declining
marginal utility of E2 out of question because the want for reward in the
hereafter is insatiable and unlimited. Increasing marginal utility of E2 is
also not possible as the reward of E2 in hereafter is unknown. A person's
evaluation of the reward will thus remain constant for each additional
unit of E2 spending. S With this type of utility function, a consumer will
go on consuming E 1 as long as its marginal utility is above 'a'. The more a
person is Godfearing the more will be the 'a' value and more of the total
spending will go to E 2 • Thus:
oE 2 OE2
E2 = F(a, Y); oa > 0; oY > 0
oa
a = F(T) aT> 0,
where T (the level of Godfearingness) is parameterically given.

E rtype consumption generates from that class of population that can
afford it. In Islamic terminology E2 will be spent only by the owner of
nisab consumer. Let us define owner of nisab as a person whose income
exceeds a certain level, say Y*.
Thus E2 = F(a, Y) > 0 when Y> Y*
= 0 otherwise.
For an owner of nisab, E2 is not 'consumption' as defined in secular

economics. In secular economic terminology E2 is a transfer from the
owner of nisab to the poor class of the population. E2 may go entirely
into the consumption of poor class or part of it may go to building up of
their capital (physical or human). Let us use subscripts U and L to denote
the values for owner of nisab (i.e. rich) and not owner of nisab (Le. poor)
consumer respectively. We can write the following equation for the two
types of consumers in the society,
EL = YL + E2 when Y < Y*.
This means, consumption of the lower income consumer is equal to his
150 Macroeconomics
total income plus the transfers from the upper income groups. (It has
been assumed that all transfers are consumed by the lower income
consumer. The possibility of the transfers being used to build up capital
of the lower income consumer can be taken up later.)
E2 = F(a, Y) }
E1=Y,.-E2 , where Y> Y*.
a = F(T)
E1 includes spending to build up durable consumer goods or to build

up productive capital. This may also include hoardings in the form of
jewelry, gold, silver, diamonds, etc. For the sake of simplicity let us
classify the components of E1 into the following.
(a) All such spendings that are termed as 'consumption' in secular
economic terminology (Cu ),
(b) Savings (S).
i.e. E1 = Cu + S, where Cu = consumption of the upper income group.
and S = savings of upper income group.
How would the total amount of E 1 , already determined by the
parameter T, be allocated between Cu and S? As already discussed, the
allocation has been left to normal consumer behaviour except that
Muslims have been categorically advised not to be extravagant.
This constraint on a Muslim will keep the level of Cu lower than the
level of Cu of a secular consumer. How much lower the level will be will
depend on how God-conscious a person is. 6 Thus we may define Cu in
case of a Muslim as
1 ~ fJ Cu = C:, where Cu = level of consumption of a secular

consumer,
where fJ = G (T) i.e. fJ is a function of the level

• h dfJ 0
of Godleanngness WIt dT > .
£".
C: for a normal secular consumer is generally determined by the level

of income, i.e. C: = F (Yu ), where Yu = income. Thus
For a Muslim consumer it is not Yu that is allocated between

consumption and savings. It is E1 left with the Muslim consumer (after
spending E 2 ) to be allocated between consumption and savings. Hence,
The above discussion is summarised below:

Let us assume that there is no borrowing so that spending (including
savings) is equal to income in case of upper income consumer and equal
to income + transfers, in case of lower income consumer.
Thus the following equations describe the elements of consumption
pattern in an Islamic economy.
CL = YL +E2
E2 = F (a, Yu ) a = F(T)
Yu = El +E2
El = Cu+S
Cu=(l-P)F(Ed P= G(T).
B. Aggregation for a Macro Framework
i. Lower Income Group Consumption Function: Consumption of a lower

income consumer depends on
(a) His own income.
(b) Income of all the persons in the upper income group living in his
neighbourhood.
(c) Level of God-fearingness of the individuals (particularly of the
upper income group) in the community.
If we want to aggregate, the aggregation of the consumption of lower
income group will simply be the additions of the individual consump-
tions in the group. Aggregation is assumed to be a simple (un weighted)
addition of the variables for all the individuals.
ii. Upper Income Group Consumption Function: Consumption of con-
sumer in the upper income group depends on
(a) His income.
(b) Level of Godfearingness.
Ignoring the effect of income distribution and of variation in (God-
consciousness) on consumption, the form of aggregate consumption
function will require simple addition of the consumptions and income of
152 Macroeconomics
the individuals in the group. The level of Godfearingness is assumed to

be the same at an average level for all individuals.
C. Dynamics of the Consumption Pattern
Dynamism in the consumption pattern of an Islamic economy arises as

the people of lower income group move into the upper income group
over time (or vice versa). The possibility of movement from lower to
upper group arises because of the improvement in the economic
condition of lower group. This will require:
(a) a desire to increase income, and
(b) an opportunity to attain to this desire.
The desire to increase income is strong for a Muslim consumer
because he would like to spend in the way of Allah and earn a reward in
the hereafter. Also it is a Muslim's religious obligation to improve his
economic condition so that he becomes a zakah payer rather than a
zakah receiver.
The opportunity to increase his income arises from the consumption
relief that he gets from the transfer from the upper income group. This
transfer taking care of his and his family's consumption gives him the
opportunity to look for a better job or to build up his capital for the
expansion of his work opportunities.
The growth in income at some point in time will shift the consumer
from zakah receiver to zakah payer. In aggregate terms this means that
the growth in income of the lower income group will shift some
proportion of the population to the upper group. We can make this shift
a function of per capita consumption in the lower income group. Thus,
we can write:
NL -F {CL} .
li- NL -I'
F<O,
where N L = proportion of population in the lower income group

N
and CL = per capita consumption in the lower income group,

NL
i.e. the proportion of the population of the lower income group will
decline as the per capita consumption in the group increases.
D. Aggregate Consumption Function of an Islamic Economy
With the above, we can now describe a consumption function in the

economy as below:
Cu = (l-P)F(Ed
E1 = Y u -E2
E2 = F (a, Yu )
CL = Yu+ E 2
NL
Ii = F(CL INL )-1
S = E 1 -Cu = Yu-Cu-E2
C=CL+Cu
Y= Yu+ YL
MACRO ECONOMIC MODEL TO TRACE THE SAVINGS,
GROWTH AND INCOME DISTRIBUTION EFFECTS OF THE
CONSUMPTION FUNCTION DESCRIBED ABOVE
A very simple macro model with the above consumption function is

described below:
1. C u = (l-P) {aO+al Ed
2. El = Yu -E 2
3. E 2 =d.-d 1 S- 1
4. CL = YL +E2
5. C = C L +Cu
6. S = E1 - Cu = Y - E2 - Cu
7. YL = {(YL)-1} x (1 +gL)+Y E2
8. flYu = 11K
9. Yu = {( Yu )- d + fl Yu
10. Y= YL+Yu
11. I=S
NL {CL} {Cu}
12. M = Ii = (M -d+Y1 {N L} +Y2 {N u} ,
where Y1 < 0 if {CL} > {CJ

{N L } {N L }-1
=0 otherwise,
154 Macroeconomics
. {Cu } {Cu }
and Y2 > 0 If - { }< { }
Nu Nu -1
= 0 otherwise.
13. N= (N)-1 (1 + gn).
14. NL = M·N.
15. Nu = (1 - M)' N
These equations are explained below:
1. C u = (1- /I) (ao +a1 Ed·
This equation determines the consumption level of the class that does
not receive zakah. We have already shown that the consumption function
of this class can be written as
C u =(I-P)F(Ed·
We know that F (E 1) is the consumption function that will prevail in a
secular economy. A conventional form of this is
C=aO+a1 Y ,
where C = consumption,
Y = disposable income.
We have E1 instead of Y, E 1, in fact, is the disposable income of a
Muslim consumer that he can spend to satisfy his material needs. Thus
we can write
Cu = (1- /I) (ao +a1 Ed·
2. E1 = Yu -E 2
This is an identity which says that the amount at the disposal of the upper
income group consumer for his spending is the difference of his income
(Yu ) and what he decides to spend in the way of Allah (E2)'
3. E2 = Z+Z1 (Yu )
or E2 = d o +d 1 S1, d 1 = 0.025.
This question determines the amount to be spent in the way of Allah.
We have already shown that the function for El can be written as
E2 = F (a, Yu)' This specifically can be written as E2 = Z1 (Yu), where Z1
is a parameter that will depend on God-consciousness. We know there is
a minimum of spending (i.e. zakah) that is obligatory upon the upper
income group (though it may spend more out of its income). The level
of God-consciousness will determine how much more will be spent

out of its income Yu' A more appropriate form, therefore, will be
E2 = Z + Zl (Yu ), where both Z and Zl are the parameters. For the
purpose of simulation some simple manipulations are done:
The amount of zakah Z = 0.025 (A -1 + S),
where A _ 1 = assets in the last year,
S = savings.
1
Also Yu = (Yu )-l +AYu = (Yu )-l + KS,
Thus E2 = 0.025A_1 +0.025S+Z 1 {(YU )-l + ~s}.
= {0.025A_1 +Zl (Yu)-d + {0.025 + i }S.
i)
Since all values in the first part are predetermined we can denote this as
do· Also the values (0.025 + are all parametrically given. Therefore,
we denote them as d l'
Thus E2 = do +d 1 S.
It will not be unreasonable to assume that the zakah and other E 2 -type
spending are calculated by individuals on the basis of the past year's
figures of assets, savings, income, etc. Therefore, we can finally write the
equation E2 as
E2 = do +d1 S-l'
All these manipulations have been done to enable the simulations to
be simple and easy. These manipulations will not be necessary and only
the equation (E2 = Z + Zl Yu ) can be used if a complex simulation
programme can be afforded or if only mathematical analysis is done as is
shown in part IV.
In the equation E2 = do + diS - 1 it can be easily seen that d 1 cannot
be less than zero. It will be equal to 0.025. If Z 1 = 0 and d 1 will be greater
than 0.025 the higher will be the value of Z 1, i.e. the higher is the level of
God-consciousness.
4. CL = YL +E2
This determines the consumption level of those who are in the lower
income group. Their consumption level has been assumed to be their
156 Macroeconomics
own income (YL ) plus transfers from the upper income group (E z ). It is
assumed that all E z is consumed. An alternative variant of this equation
could be to include only a part of E z as going to CL and the rest of E z
going to savings (building up capital stock of those who are in the lower
income group). To avoid complexities in the analysis, this variant is not
being considered presently but its effect can be considered later on.
5. C=CL+C u
This is an identity indicating that consumption in the economy is the sum
of two classes of population in the economy.
6. S = E1 - Cu = Y u - E z - Cu
This identity indicates that savings will be done by the upper income
group and that savings will simply be its income minus what it consumes
or spends in the way of Allah.
7. YL = {(YL ) - l (l+gL)}+yE z
This equation determines income for the population that is in the lower
income group. The first part of their income, i.e. (YL )-l (1 +gL) has
been assumed to be increasing at some exogenous growth rate (gL).
This population obviously does not have capital stock. But this
population known that to be always in the receiving class of zakah and
charities is not encouraged in Islam and that he has to improve his
economic condition. Also, he wants to earn reward by spending in the
way of Allah as the upper income group are doing. So he will make
efforts to increase his income.
Note that YL has been kept independent of Y u • In fact, in an Islamic
economy, Y u may positively affect YL at least for those who are employed
by the upper income group. In an Islamic economy, the wage pattern will
be different from that in capitalist society. The 'Fair Wage' theory or an
employer's paternalistic considerations will be more relevant in an
Islamic economy. This dependence on YL and Yu is presently ignored to
keep the analysis simple.
Apart from this exogenous growth some increase in the income of this
class will be contributed by the transfers from the upper income group.
The transfers, even if they do not contribute to the savings of lower
income group, will contribute to their efficiency. The use of zakah on
health and education will improve their human capital and hence will
contribute to their income. The second part yE z represents this
contribution.
8. AYu = 11K
9. Yu={(Yu)-d+AYu
These two equations determine income for the upper income group. The
change in the income of this population is determined by the investment
that they make and the incremental capital output ratio - K (a param-
eter) of the economy. This assumes a fixed coefficient production
function for simplicity. Any other form of the function can also be used.
The change in Yuis thusAYu = 11K. The current year's Y u, therefore, is
simply the sum of the past year's Y" and current year's change in Y".
10. Y= Y,,+YL
This identity determines national income as a sum of the incomes of the
two groups of population.
11. 1= S
The assumption of absence of borrowing (external or internal) leads to
this identity between savings and investments in the economy.
NL {eLl {eu}
12. M = Ii = (M)-t +Yt{N L } +Y:z {Nu } •
This equation determines the percentage of population that will be the

lower income (zakah receiving) group.
In a dynamic economy where the income of both classes is increasing,
where there is a mechanism for transfer of incomes and where there are
motivations and opportunities to move to higher groups, the percentage
of population in the two groups cannot remain constant. The percentage
will be a function of population in the lower group and will decline as the
consumption in this class increases for some part of this population will
move in a position to pay zakah and, not remain in zakah receiving
group. Yt (a parameter) will determine how much decline in M will be
i~:~
brought about by a certain increase in the per capita consumption of this
class. If does not increase or rather declines then Yt will be zero and
M will remain same as in the past year.
Also it is possible that due to decline in the income of the upper income
group some part of this population may enter into the zakah receiving
group. Y:z (a parameter) will determine how much increase in M will be
i~:~
brought about by a certain decline in the per capita consumption of this
class. If does not decline or increases then M will remain the same
as of last year (i.e. Y:z will be zero)
{eLl {ell}
M = (M-d+Yt {N L } +Y:z {Nu } ,
158 Macroeconomics
If {C L } > {C L }
where YI < O.
{N L } {NL}-I
= 0 otherwise
= 0 otherwise.
13. N = N - I (1 + gn)
Population in the economy is assumed to grow at a constant rate (gn) per
annum.
14.NL=M·N
15. Nu = (1- M) N
These two equations determine the population in the two classes.
1M PLICA TIONS OF ISLAMIC CONSUMPTION FUNCTION
1. Savings-Short Term
The savings function in an Islamic economy will be of the type
S = Fo+FI WY,
l-z 1
where FI = 1.025 -0.025a, (1- P) {l- (1- P) ad·
The implication for savings under different situations is discussed

below.
Case I: Zakah treated as tax so that only zakah is paid and there is no
God-consciousness
This means no other spending is made in the way of Allah and no
restrains on self-consumption are exercised and a Muslim behaves as a
secular consumer.
This means:
P= 0 and ZI = 0
1
FI = 1.025-0.025al (1-ad·
For a secular consumer in a secular economy the savings function is:

S = ao + (1 - ad WY.
Since the denominator in F 1 is greater than unity because a 1 is less than
unity, hence:
Fl < l - al'
Thus the propensity to save is reduced with zakah in this case.
The difference, however, will be very low at high levels of propensities
to consume and will be marginally higher at lower propensities to
consume. In an economy that has a marginal propensity to consume
equal to 0.80 (a reasonable figure for a developing country) the
introduction of zakah as a tax will reduce marginal propensity to save by
0.5 percent, i.e. instead of 0.20 it would be 0.199 (see Table 10.1).
TABLE 10.1 Effects of introduction ofzakah as a tax on short-run savings at

different levels of marginal propensity to consume
Marginal pro- Percentage

pensity to con- Value ofF I Value of(1-al) decline in mar-
sume before marginal pro- marginal pro- ginal propensity
introduction pensity to save pensity to save FI as % of to save as a
ofzakah (al) after zakah without zakah (I-ad result of zakah
1.00 0.000 0.00 0.00 0.0

0.90 0.1998 0.10 99.8 0.2
0.80 0.1990 0.20 99.5 0.5
0.70 0.2977 0.30 99.2 0.8
0.60 0.3960 0.40 99.0 1.0
0.50 0.4938 0.50 98.8 1.2
0.40 0.591 0.60 98.5 1.5
0.30 0.688 0.70 98.3 1.7
0.20 0.784 0.80 98.0 2.0
0.10 0.8802 0.90 97.8 2.2
0.00 0.9756 0.00 97.0 2.5
The maximum effect will be a 2.5 per cent decline when the marginal
propensity do consume is zero.
This simply means that whatever they save from their additional
income will be reduced by the amount of zakah at the rate of 2.5 per cent.
If they were saving all of their additional income, then this saving will be
reduced by 2.5 per cent and if they were saving only 20 per cent then this
will be reduced by 0.5 per cent of 20 per cent by zakah.
160 Macroeconomics
Case II. Muslims understand the importance of spending in the way of

Allah but their own consumption patterns are the same as of
secular consumers
This means P= 0 but Z 1 is positive. 7 In this case
(1- Zd
F 1 = 1.025 _ 0. 025a l {l- ad
F 1 in this case is less than that in case I. That is savings in the short run are
further reduced. The reduction will be more the higher is the value of Z I.
Case III. Muslims are not inclined to spend in the way of Allah more than
the minimum required. They, however, rationalise their own
consumption pattern as taught by the Quran and Sunnah
This means Z 1 is zero but Pis positive. In this case Marginal Propensity
to Save, MPS = FIW,
1- (1- P)al
where F 1 = ---------'--=---
1.025 - 0.025a l (1 - P)
Let us compare this with the secular marginal propensity to save
MPS = (1-al)W
W is common in both so we compare F 1 and (1 - al).
The numerator of F 1 is greater than (1 - a 1 ). The numerator of F 1 is,
however, reduced by the denominator being larger than unity. Whether
1- (1- P)al
is greater than (1 - ad will depend on the
1.025 - 0.025al (1 - P)
values of Pand al·
The restraint on self-consumption reduced the overall consumption
by a certain factor. But reduced consumption means more zakah. The net
effect is shown in the following table. Table 10.2 shows MPS* (i.e. MPS
of an economy that has some positive values of P). The values of M PS*
have been shown for different values of P at two alternative levels of
M PS (which is the propensity to save in the absence of Islamic
injunctions). The two alternative values have been assumed to be 0.20
and 0.10 which is a range generally observed for the present Muslim
countries.
The M PS* will be higher than M PS for higher values of p.
Cases II and III are also unlikely in an Islamic economy. Both Pand Z 1
depend on the level of Godfearingness. It is very unlikely that one of
them is zero and the other positive.
TABLE 10.2 Values of MPS· for different values of fJ when ZI =0

When MPS = 0.20 When MPS = 0.10
fJ i.e. when a l = 0.80 i.e. when a l = 0.90
0.Q1 0.209 0.100

0.02 0.217 0.118
0.05 0.241 0.150
0.10 0.282 0.191
0.20 0.363 0.282
0.30 0.445 0.373
0.40 0.527 0.465
0.50 0.609 0.558
In comparing case III with case II we find that one parameter of an

Islamic economy (Zl) will have a negative effect on saving propensity
whereas the other parameter (p) will have a positive effect. Their
combined effect is considered in case IV.
Case IV. Muslims not only spend in the way of Allah, but also rationalise
their own consumption as taught by the Quran and Sunnah. A
likely reflection of an Islamic economy
In this case: Marginal Propensity to Save is MPS· = F1W
F - (I-Z1) {1- I-P }
1 - 1.025 _ 0.025a 1 (1 _ p) ( )al .
Let us compare this with secular marginal propensity to save,

MPS = (l-adW.
M PS* (i.e. marginal propensity to save of an Islamic economy) will be
greater than MPS if
(I-Z ){I-(I-P)ad
1 (1 )
-----'-------.:.... > - al
1.025 - 0.025al (1- P)
MPS* has two components
(i) 1 - (1 - P)al
(ii) 1.025 - ~.~2~:1 (1 - P)

It is obvious that the first component is greater than (1 - al) as 0 < P
< 1. But the second part is clearly less than unity because Z 1 > 0 and
{1.025 - O.025atCl - P)} > 1 as al> P > 0 and < 1.
162 Macroeconomics
The outcome, whether M PS* will be greater than M PS, will therefore,
depend on the empirical values of Z 1 and fJ (which in turn will depend on
the level of Godfearingness in the society).
Let us assume Z 1 = 0.025. It should be remembered that this is a
proportion of his annual income that a Godfearing man will spend in the
way of Allah, in addition to 2! per cent zakah that he is obliged to pay on
his wealth. Also let us assume M PS in the economy before Islamisation
to be 0.20 (i.e. a1 = 0.80). Now, assuming different hypothetical values
for fJ that may be observed after Islamisation, the impact on the marginal
propensity to save is shown in the following table:
TABLE 10.3 Values of MPS* for different values of Pwhen Z = 0.025
P MPS* MPS*-MPS
0.000 0.194 -0.006

0.005 0.198 -0.002
0.008 0.200 0.000
0.010 0.202 +0.002
0.020 0.209 +0.009
0.050 0.233 +0.033
It can be seen that when fJ = 0 (which is same as case II discussed

earlier), there will be an immediate negative effect on the marginal
propensity to save. But a very small value of fJ would make the marginal
propensity to save higher even in the short run. This means that if people
are willing to slightly change their lifestyle to reduce what Islam calls
israf (prodigality), zakah cannot have a negative effect on the (macro)
marginal propensity to save in the economy. As is evident from Table
10.3, even as low as fJ a 0.008 would not allow any negative effect on the
propensity to save. A fJ value equal to 0.008 would mean that if a person
was having propensity to consume 0.80 when operating in an un-Islamic
environment, the Islamic environment and Islamic values would cause
him to reduce this to at least 0.794 which is not an unreasonable
assumption. The injunction to avoid prodigality can have a much
stronger effect on consumption particularly in the modern environment
of developing countries where consumption patterns are substantially
dominated by conspicuous consumption. The higher the value of fJ the
more the positive effect on the propensity to save.
If Z 1 value is greater than 0.025 (i.e. people like to spend more in the
way of Allah) a higher value of fJ will be required to avoid the negative

effect on the propensity to save. Since both Z 1 and fJ depend on the level
of Godfearingness, fJ is expected to move with Z 1, hence reducing the
negative impact on the propensity to save. Thus, in an Islamic society, the
marginal propensity to save is likely to increase even in the short run.
LONG-RUN SAVINGS
This part can be written only after simulations for future can be made by
assigning different values to the parameter to see the growth path of
savings. Since transfers from upper income groups contribute to the
income growth in the lower class, savings will ultimately be higher in all
the four scenarios compared to the scenario of a secular economy.
GROWTH AND INCOME DISTRIBUTION EFFECTS
This part also can be written only after simulations are done.
Theoretically, it is easy to visualise within the framework of the above
model that growth and income distribution implications of Islamic
consumption pattern will be favourable, i.e. growth will be higher and
income distribution will be more egalitarian.
CONCLUSIONS AND POLICY RECOMMENDATIONS
Comparison of savings, growth and income distribution effects by

simulating the model under different scenarios can highlight various
implications and trade-offs. The following general conclusions can be
drawn on the basis of the above analysis, even without running the
simulations.
For developing Muslim countries striving for resource mobilisation
for development, Islamisation provides a new hope for the economy. The
motivation to consume less and save more to improve one's own
economic conditions as well as economic conditions of the lesser
privileged in the community comes from one's conscience, i.e. from one's
religion. It cannot be denied that all policies of development and
resource mobilisation of developing countries fail because they lack
motivation on the part of the individuals and because their policies are
164 Macroeconomics
hardly in harmony with the social and religious norms of the individuals.
Thus Muslim countries have nothing to fear from the process of
Islamisation on macroeconomic front.
The process of Islamisation that would bring favourable results as
indicated in the earlier sections assumes that Muslims practice Islamic
values. The process of Islamisation, therefore, should aim at inculcating
Islamic values in the life of Muslims. Improving Islamic economic
injunctions through legislation, though, may still be beneficial in the long
run. It can be shown from the simulation model that if we impose zakah
through legislation without inculcating Islamic values (particularly
economic values), there is a likelihood of immediate adverse effect on
savings. The speed of achieving favourable effect on growth and income
distribution in the long-run will be extremely slow compared to the
situation where people understand and practice Islamic economic values.
Priorities in the Islamisation of economy should be on bringing about
Islamic values in the society through mass education using mass media as
well as educational institutions.
Comparison of cases I to IV discussed earlier suggest that if the
government wants to implement the zakah system by legislation it
should simultaneously launch an educational and moral suasion pro-
gramme to reduce israf(prodigality) in consumption. Reforms in Import
policies and the tax structure can help in achieving this objective. In
short, the starting-point for any government should be the one suggested
by case III, i.e. impose zakah at the rate of 2.5 per cent along with policies
to reduce israf in consumption both in the public and private sectors.
APPENDIX
Cu = (1- P)ao+ (1 - P)alE l

= (1 - P)ao + (1 - P)al (Yu - E 2)
C u + E2 = (1- P)ao + (1- P)alYu - (1- P)a l E 2

= (1- P)ao + (1- P)alYO + {l- (1- P)ad E2
= (1- p)ao + (1- P)al Yo + {I - (1 - P)al} {Z + Z 1Yu }

= (1- P)ao + (1- P)alYu + Z + ZlYu- (1- P)alZ
- {(l- P)al}ZlYu.
Let (1-p)=A; (1-P)(l-Zl)=B

Cu+E2 = (Aao + (Ba1 + ZdYu+ (1- AadZ
= Aao + (Ba 1 + Z l)Yu + 0.025(1 - Aa1)A_1
+ 0.025(1- Aa1)S.
Since Z = 0.025(A - 1 + S)
S = Y u-Cu-E 2 = -Aao+ {l- (Ba1 +Zl)} Yu
- 0.025(1 - Aa1)A -1 - 0.025(1 - Aa1)S
{(l +0.025(1- a1A)}S = - {Aao +0.025(1- AadA_ d
+{l-(Ba1 +Zd}Yu·
Let 1.025 - 0.025a1 A = E and - {Aao + 0.025(1 - Aa1)A - d = F
ES = F + {1- (Ba 1 + Zl)}YU
- F {l- (Ba1 + Zl)}YU
or S=T+ E .
F
Let E = Fo; F1 = {1- (Ba1 +Zd}/E,
and let Y JY = W, i.e. share of upper income group in the national

income
S = Fo+F1WY.
This is savings function for an Islamic economy. The savings function
for a secular economy in similar conditions will be:
S· = Yu-C u = Yu-ao-a1Yu
= -ao+(1-a 1)Yu
= -ao+(1-a 1)WY
11 Macroeconomic
Relations in the
Islamic Economic
Order*
INTRODUCTION
Schumpeter tried to enunciate in his monumental work, that economic

science, if it is to be a science, must be bereft of all shades of value
judgements. He defined 'scientific economics' to mean, 'the sum total of
the historical, statistical and theoretical techniques, together with the
results they produce'.1 The impingement of all shades of value
judgements was to be considered outside the pale of economic theory,
because, as Schumpeter claimed, such judgements leave economic
analysis unaffected. Notwithstanding this claim the enunciation could
not be sustained in the body of Schumpeter's work.
The fact remains that every revolutionary economic doctrine has had
an implicit interrelationship with the history of political and moral
philosophy prevalent over a period of time. 2 An example of this is the
competing views of the Marginalist and the Relativist schools of thought
in the mainstream of modern economics with respect to the problem of
resource allocation.
The marginalists propounded a theory of productivity that is steeped
on the assumptions of a perfectly competitive market eqUilibrium. The
concept of economic efficiency is synonymous with these conditions of
resource allocation attained in the milieu of perfect competition. The
relativist school turned to the methodology of input -output analysis. It
explained the process of resource allocation across sectors in terms of
* This chapter was presented as a paper by the author at the Third World Congress of
Social Economics, California State University at Fresno, 16-19 August 1983. An
abridged version of this chapter is to appear in the International Review of Economics and
Ethics.
166
Macroeconomic Relations in the Islamic Economic Order 167
market shares of intermediate goods and services. Economic efficiency

in this system is explained by the technical conditions of production and
not by the marginal productivities of labour and capital. 3
Recently the resurgence of a New International Economic Order had
brought into focus the need for rethinking in the theory of economic
policy.4 The focus has been on the development of the goals and
instruments for economic co-operation among developing countries,
based on issues of the Common Fund, Integrated Commodity
Programme, debt relief, trade preferences and so on. 5
Likewise the Basic Needs Approach (BN) to economic development
focused on the economics of redistribution of basic needs to the
individuals and households in the least-developed countries. The BN
embraces the goals of rural development, redistribution with growth
and equity-oriented approaches to economic development. 6
The few cases of shifts in traditional economic theory and policy
mentioned above, signify the pressing need of the time, for developing
economic theory and policy on the lines of economic co-operation,
equity, income redistribution and still sustaining balanced growth.
Islamic economics is an emerging area of economic thought that
comprehends these goals. At the same time it marks a reconceptualis-
ation of economics that is value laden and affected by the value
judgements of the Islamic faith. We now turn to a brief delineation of the
major principles of this Islamic economic order.
MACROECONOMIC PERSPECTIVES OF THE ISLAMIC

ECONOMIC ORDER
The Fundamental Principles
The central goal of the Islamic economic order is the attainment of

balanced growth and development in the light of a transcendental
consideration - that of a righteous community promoting the Laws of
God on earth. In order to achieve this goal three fundamental principles
are followed. In turn these principles are mobilised by the choice of
critical macroeconomic instruments specific to the Islamic economic
order.
The fundamental principles of the Islamic economic order are: 7
I. The Principle of Unity and Brotherhood,
2. The Principle of Work and Productivity,
3. The Principle of Distributive Equity.
168 Macroeconomics
The three principles are interconnected in the sense that they help to
generate a given chain of relations in a general equilibrium framework.
The rationalisation and development of this set of general equilibrium
relations in an Islamic macroeconomic order is our objective in this
chapter. In order to undertake this task we shall first explain briefly the
above-mentioned principles and the macroeconomic instruments
underlying these principles.
In the Islamic economic context the Principle of Unity and
Brotherhood is the crux of all the relations in this economic order in that
it teaches man how to relate and deal with other men in the light of his
relationship with God. Thereby social justice becomes the overriding
goal of all economic transactions. In Islam the capacity to understand
and dispense this goal of social justice emanates from the knowledge and
practice of the principles of the Quran.
The Principle of Work and Productivity states that an individual's
wages must be proportionate to the amount and category of labour
performed by him. 8 The important point to note in this principle is, that
whenever an individual acquires income greater than is due to him by
dint of his labour and resources, he commits an excess. The acquisition
of this excess is prohibitive in Islam, as it negates the Principle of Unity
and Brotherhood.
The Principle of Distributive Equity states that the Islamic state has
the right to redistribute private property. The imperative to equitably
distribute income and wealth is binding on both, the state as well as the
individual. Redistribution here is not, however, to be considered as
charity. Rather it is to be treated as a means of increasing the productive
transformation of national income and wealth in the form of employ-
ment and welfare of the citizens. This principle thereby reinforces the
Principle of Unity and Brotherhood.
The Islamic Macroeconomic Instruments
The three central principles of the Islamic economic order are mobilised
by certain key macroeconomic instruments. These are briefly discussed
below:
1. The Abolition of Interest
In order to establish the Principle of Unity and Brotherhood Islam

makes the elimination of interest in all economic transactions as
binding. The principal argument against interest is that it is a prefixed

amount or a percentage set solely on the basis of a speculative, rather
than an actual cost of capital. It is therefore, neither a function of the
capital in use nor the labour input in production. Because of this
exogenous nature of interest in the total cost of production it is replaced
in the Islamic economy by profit. At this point it is suggestive for our
future analysis to switch to the discussion of interest in terms of the rate
of interest, and of profit in terms of the rate of profit. It has been
suggested by some Islamic economists that the admissible rate of profit
would be in a range of normal profit rates earned by firms of different
categories in an economy-wide situation. 9
2. The Institution of Profit-sharing
The replacement of the rate of interest by the rate of profit and the
activation of the latter in an economy-wide situation is accomplished
through the Islamic profit-sharing mechanism known as mudarabah.
Under mudarabah partners in a joint venture can advance capital,
labour or enterprise or a combination of these on the basis of a
contractual agreement to share the profits of the joint venture by
preassigned percentages. The preassigned percentages are determined
by relative shares of capital advanced by each partner in the case of a
capital-using enterprise, or by the relative shares of wages forgone by
labour in the case of labour-management joint venture, or even by the
relative shares of the money value of time put in by an enterprise, such as
consulting firm.10 Profit-sharing in this sense does not, however,
supplant the normal entitlement for wages, salaries and fees.
3. The Abolition of Wasteful Consumption
The third category ofIslamic macroeconomic instrument is the check on

wasteful consumption, known as israf The economic media through
which this constraint is put into effect is the institution of mudarabah,
which, because of the predominance given to the generation of profits
and to profit-sharing, automatically brings about a desired allocation of
money capital between consumption and investment activities, giving
greater emphasis to investment in real capital.
The action of mudarabah on restraining excessive consumption is
170 Macroeconomics
guided by the Islamic norm of consumption -investment behaviour. The

Islamic consumption-investment behaviour warrants that an Islamic
society must give, (i) consumption priorities to the necessaries and
comforts of life in this order, (ii) excessive consumption and thereby,
excessive production of any type of good is not recommended,
(iii) savings in the form of real investment to produce the necessaries and
comforts of life and more capital goods that increase the productive
capacities in the following periods of time is highly encouraged.
The institution of mudarabah, working through the elimination of
interest and the restraint on wasteful consumption, must increase the
productive use of capital into real investments. Thereby the Principle of
Work and Productivity of the Islamic economic order is enhanced.
On the other hand, the Principle of Distributive Equity of the Islamic
economic order is implemented by the fourth important and conjoint
macroeconomic instrument, the mandatory payment by citizens of an
Islamic state, of a capital tax on savings and accumulated wealth
existing in cash form. This capital tax is known in Islamic terminology as
zakah.
4. The Institution of Zakah
The capital tax of zakah is collected from all well-to-do Muslims in an

Islamic state, and redistributed totally, for the purpose of improving
social welfare among the needy. The proceeds of a zakah fund cannot be
utilised for project development purposes, which in tum is a regular
function of an Islamic government like any other government and is
financed out of other autonomous expenditure.
The important point to note about zakah is that it is not a tax on
personal or corporate income. Rather it is a tax, not to be lower than 2.5
per cent, on all savings accrued over the years and available at the point
of being 'zakated', and on assets in the form of cash holdings that are left
idle for at least a year.
The institution of zakah being a check on the accumulation of
hoarded capital or idle wealth in cash form, automatically must favour
investment into real capital. It thereby links up with the other
macroeconomic instruments, namely, mudarabah, the abolition of
interest and the restraint on israf The result of this interrelationship is
the generation of certain macroeconomic general equilibrium relations
in the Islamic economic order.
Interrelationships Among the Principal Macroeconomic Instrnments
It can be noted from the above discussions that the success of the
mudarabah system depends crucially upon the performance of the
capital goods sectors. In tum the performance of the capital goods
sector depends on the increased propensity to invest in this sector that
results from the constraint on excessive consumption and the unlimited
preponderance of investment activity as a natural corollary of the
restraint of isra! 11
Finally the propensity to invest is further augumented by the presence
of zakah, which was defined earlier as a specific capital tax on savings
and idle assets held in cash form. Zakah would therefore have a strong
multiplier effect on employment, output, profit and price stabilisation,
through the media of increased investment. The multiplier effect of
zakah is so strong that investment will be undertaken even when the
expected rate of profit is zero.12
The effect of zakah on employment is two-fold. First, it improves the
general level of employment through its multiplier effect on investment.
Higher capital expenditure in real investments brings about higher value
added and thereby higher profits. The derived demand for labour would
therefore increase as a result of the improved levels of capital
expenditure and output.
The second function of zakah in respect to employment is its potential
role in improving certain structural types of unemployment, such as the
unemployment of depressed segments of society segmented by charac-
teristics oflow human capital, poverty, age, debility, etc. It is well known
from the literature that structural forms of unemployment are not easily
amenable for improvement by increasing the aggregate demand for
goods and services. On the other hand, in the Islamic economic order the
zakah expenditure is put aside and year-marked for alleviating precisely
the structural problems of society, of which structural form of
unemployment is a major issue.
This functional role of zakah on structural unemployment suggests
that national income accounting comprises expenditures in consump-
tion and investment, and government expenditure, subdivided into
zakah expenditure and other autonomous government expenditure.
This division of nationaI.income accounting implies that the alleviation
of structural form of unemployment will be non-inflationary. The
situation is similar but less inflationary than the well-known government
job-creation programmes, wherein the cost of creating an additional job
172 Macroeconomics
is much lower than the cost of creating an equivalent full-time

employment, and the longer-term prospects of gains on labour produc-
tivity are higher, via lower wages and increasing marginal productivity
of labour. 13
In the foregoing sections we have outlined the workings of the major
instruments of the Islamic macroeconomic order. We have also
established the critical inter-relationships among the rate of profit and
the investment-consumption characteristics of an Islamic economy
with the marginal propensity to invest, predominantly in capital goods,
and the multiplier relationship of zakah with employment, investment
and output. 14 The interactive workings of these relationships generate
the general equilibrium macroeconomic relationships in the Islamic
order. To the formulation and analysis of this general equilibrium
system we now turn.
GENERAL EQUILIBRIUM ANALYSIS IN AN ISLAMIC

MACROECONOMIC ORDER
General Properties of the Monetary Sector
The first question would be to see how banks in an Islamic economy

would function in the absence of interest. The answer to this is that in the
Islamic economy the central bank would not be in a position to create
any amount of supply of liquidity based on the expected demand for
cash balances by creditors. The speculative demand for cash balances
would therefore be irrelevant in an Islamic economy, causing thereby no
gaps between the ex-ante demand for cash balances and the supply of
liquidity that would otherwise result from the existence of a speculative
demand for cash balances.
The mechanism by which an ex-ante demand for cash balances is
exactly satisfied by the supply ofliquidity is the following. In the system
of mudarabah the rate of profit replacing the rate of interest, the ex-ante
demand for cash balances will be reduced to an actual demand for cash
balances by the force of the expected rate of profit. The expected rate of
profit being an average rate for a random sample of firms is a
determinate quantity. On the other hand, the supply of liquidity is not
exogenously determined by the central bank, but rather is a function of
the realised or expected rate of profit. The reason for this is that the bank
itself is a sharer of the total profits that accrue from a joint venture with
business entrepreneurs.
Siddiqui shows in his formalisation of a model of the monetary sector

equilibrium in the presence of the profit-sharing mechanism that the
monetary sector has a constant tendency to equilibrate, with the supply
curve of money shifting rightwards due to shifts in the level of income,
following increased prospects of profits, and simultaneously the demand
curve for cash balances shifting upwards as entrepreneurs go on a spree
of investments. IS It was not shown, however, whether the demand and
supply curves of money will experience their full shifts, only on the
impact of a change in income, or whether part of the demand could be
satisfied by internal sources of profits now distributed among firms and
households.
The upshot of the demand and supply schedules of cash balances in
the presence of mudarabah is that the supply curve of liquidity will be
elastic and positively sloped. The positive elastic supply curve of
liquidity is the result of profit motivation. It is also reinforced on the
grounds that increasing expectations for profits will reduce the risk for
the Islamic Central Bank in joint ventures. It would thereby have a
higher propensity to create more money supply. The supply of money, as
it comes by, must be invested into real capital in order to realise the
expected rates of profit.
The demand curve for cash balances in the presence of the rate of
profit would be a negatively sloped elastic curve. This can be understood
on grounds of the following argument.
As the demand for cash balances increases an increasing flow of
liquidity will be invested into real capital. As investment in capital goods
increases incrementally the marginal efficiency of investment would
decline incrementally. This would in turn signal a decline in the
rate of profit on invested capital, with increasing demand for cash
balances.
On the other hand, as the rate of profit is increasing, entrepreneurs
will have more money available for an internal financing of their
investment needs. Their external demand for money capital will
decrease. The demand for cash balances will therefore decrease with
increasing rates of profit.
With the shapes of the demand and supply curves of the monetary
sector of the Islamic economy thus determined, the equilibrium rate of
profit and level of cash balances in the economy are determined when the
ex-ante demand is exactly satisfied by the supply of liquidity. This
happens at the intersection of the demand and supply curves of money at
a feasible normal rate of profit. This economy-wide positive normal rate
of profit is the weighted average of the normal profit rates for a random
174 Macroeconomics
sample of firms. A range of admissible normal rates of profit can be

generated by the selection of different samples of firms.
The Profit-Liquidity Trap
Since we are now choosing from a range of normal rates of profit specific
to given groups of firms it is logical that there will be a lower bound for
the rate of profit. At this lower bound rate the demand for cash balances
by firms could be very high. Subsequently the liquidity derived will be
invested into real capital, predominantly in the hope of moving up into a
higher level of profitability.
Figure 11.1 shows, that at the lower bound of the profit rates Po' the
demand for cash balances is infinitely elastic, shown by the segment DIY.
At higher rates of profit the demand curve is elastic and negatively
sloped, shown by the curve DD. Finally, when the profit rate improves
from the level Po to P~, the demand curve for cash balances again
be.comes elastic as shown by the curve IY'IY'. This shift in the demand
curve has been made possible by an increase in demand for cash balances
from Mo to M~. Note that the shift of the demand curve for money from
DDIY to IY'IY' is not the result of a change in the normal rate of profit
from Po to P~, but rather as a result of the deliberate policy of the
Islamic central bank to supply additional liquidity in the amount
M~ - M 0' based on the expectation of a change in the profit rate from
Po to P~.
The supply curve of money has thereby shifted from SS to S' S'. The
shape of the new supply curve is shown to rise as an elastic positively
sloped curve from the horizontal demand curve for money, because
under the mudarabah system banks will supply the liquidity in demand in
the hope of realising the expected rate of profit in a joint venture. The
supply curve of money is for all practical purposes an elastic positively
sloped curve in an Islamic monetary sector.
The Monetary Sector Equilibrium
The equilibrium of the monetary and expenditure sectors of the

economy is explained by the IS-LM relations in the Keynesian
macroeconomic system. In the Islamic macroeconomic system, because
of the role of profit rate in the monetary and expenditure sectors, the
Islamic IS-LM relations, denoted henceforth by llS-1 LM, have a very
different interpretation.
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Metawalli has rationalised in his work, that the IS curve is replaced in

the Islamic economy by the ISZ (investment, savings, zakah rate)
curve. 16 His argument runs as follows: in an interest-free economy the
demand for money is a function of income only. Also to each level of
investment there is a rate of profit and a rate of zakah. In equilibrium
investment would equal savings. This would yield the ISZ curve as the
locus of income and profit rates for which investment, savings and zakah
rates are determined in equilibrium.
The departure of our work from Metawalli's work is merely in the
forms of the macroeconomic relations, not in the arguments underlying
them. Asin Metawalli's work, our demand function for cash balances is
determined by the transaction and precautionary motives. The speculat-
ive motive does not exist. However, contrary to Metawalli's formalis-
ation it is the rate of profit and not zakah that is the principal instrument
in defining the demand and supply of money, in our formalisation.
The demand function for cash balances is of the form
M" = 11 (Y, P)+ 12(Y, P), (1)
= 1 (Y, P)
or, in the linear form, as
M" = a+alY+a2P, (2)

where M" denotes the total demand for cash balances,
11 (Y, P) denotes transaction demand,
12 (Y, P) denotes precautionary demand,
1 (Y, P) denotes the general function combining
11 (Y, P) and 12 (Y, P).
Y denotes the level of income,
P denotes the rate of profit,
a, a lo a2 are constants.
aM" <0
ap (3)
The supply function of liquidity is of the form

M. = M.(Y, P), (4)
or in the linear form as

M. = b+b I Y+b 2 P, (5)
where M. denotes the total supply of liquidity,
b, b l , b2 are constants
aM. 0 aM. 0 (6)

ay >, ap >
For a monetary sector equilibrium we must have
Md=M•. (7)
2. The Expenditure Sector Equilibrium: the IS-Schedule
In the expenditure sector the investment function J is given by

J =J (Y, P, Z), (8)
or, in the linear form, as
J = c+CIY+C2P+C3Z, (9)
where Z denotes the zakah expenditure
C, Cl, C2, C3 are constants.
iJJ iJJ iJJ
ay> 0, ap < 0, iJZ < 0 (10)
The negativity of the expression iJJliJP means that as new investments

are being undertaken, the cost of investment will increase in the projects
receiving investments. Hence the rate of profit will initially decline as
investment increases. Alternatively, the same expression means that with
increasing investment in a given facility the marginal efficiency of
investment will decline. This will be followed by a decline in the rate of
profit.
The positivity of the expression iJI I iJZ means, that with increasing
amounts of zakah, the propensity to invest will increase. However, the
zakah rate can be varied only marginally above the level of 2.5 per cent.
There is a serious difference in opinion on this issue. Some schools of
Islamic theology are adamantly against the variability of the rate of
zakah. The more progressive school of Islamic scholars find the
178 Macroeconomics
variability of the zakah rate necessary in case of economic exigencies. The

zakah rate cannot fall below 2.5 per cent as this has been set by the
Prophet Muhammad under specific rules of the Quran.
The consumption function is still given by C,
C = C(Y), (11)
or in the linear form as
(12)
where d and d 1 are constants.
National accounting identity in the Islamic economy is given by,
Y= C+l+Z+G, (13)
where Z denotes zakah expenditure,
G denotes other government expenditure
Zakah expenditure can be further expressed as a function of savings
as
Z = e+e1S, (14)
where S denotes savings
e, e1 are constants. e1 can be interpreted as the zakah ratio.
On substituting the various expressions in the national accounting
identity we obtain
Y = c+d+G + Cz P
x +
I+C3 Z
x . (15)
l-C 1 -d 1 l - c 1 -d 1 l-C 1 -d 1
We can take G to be exogenously determined, so that G = Go.
Furthermore, by putting S = I for expenditure sector equilibrium,
and the expression I from equation (9), we obtain
Z = e+e1S
= e+e1 1
= e+e1(c+C 1Y +CZ P+C 3Z),
i.e. Z = e1c1 + C1 e 1 xY+ e1 cZ xP. (16)

l-e1c3 l-e1c3 l- e1c3
On substituting Z from expression (16) into expression (15) we obtain
an expression for Y in the form
Y= A+BP, (17)
where A is a function of the exogenous parameter Go,

B can take both positive as well as negative values depending
upon the sign of,
( 1- 1 +C3 el cl )-1
x--=-~ (18)
l-Cl-dl l- l 3e c
Expression (17) gives the variant of the IS-relation in the Islamic
macroeconomic order. It is referred to here as the IIS-relation. Clearly
the IIS-curve can be either positively or negatively sloped.
A negative relation between Y and P can be explained via the
investment function. As investment increases, the marginal efficiency of
capital declines, as well as the cost of investment increases. The initial
rate of profit thereby decreases. However, a decline in the rate of profit
would not necessarily imply a decline in output Y, for there is already an
existing stock of capital expenditure in the economy sufficient enough to
generate increasing levels of income. On the other hand, a positive
relation between Y and P signals, as in the Keynesian system, that the
sum of marginal propensities to consume and invest out of net national
product exceeds unity, mainly because of the excess demand for
investment in the Islamic economy, which remains unsatisfied by the
available savings. 1 7 This is, of course, a situation of disequilibrium in the
expenditure sector in the Keynesian system. To restore equilibrium an
economic policy would be to distribute much of the increasing levels of
profits as dividends. In this way there will be money capital available for
households and firms to finance their investments internally. Otherwise,
money supply will have to be stepped up to meet the demand for
additional investment. But this will be only at the cost of demand-pull
inflation. The IIS-schedule therefore, has specific significance in the
Islamic macroeconomic order, which is different in interpretation from
the Keynesian IS-schedule.
Tbe Islamic LM-Scbedule
The monetary sector equilibrium is signified by the LM-schedule in the

Keynesian system. We shall now investigate what the form and functions
of an LM-shedule can be for the Islamic economy. We start with the
premiss that the supply function of money is not exogenously set in the
Islamic economy. Rather, as mentioned earlier, the supply is constantly
made to adapt to the ex-ante demand for money in respect to the
movements in the rate of profit. The monetary sector equilibrium is then
180 Macroeconomics
given by
M,,=M.
or in the linear form by
a+at Y +a2P = b+b t Y+b 2P. (19)
This yields
_-
P- --x Y+D
at -b t
(20)
b2 -a2 '
where D is a constant and may be a function of the monetary reserve
which can be considered as an exogenous parameter. The reserve ratio
can be manipulated by the Islamic Central Bank by suitable open market
operations.
Equation (20) is the variant of the LM-schedule for the Islamic
macroeconomic order, and is referred to here as the ILM-schedule.
There is no fixed sign for the slope of this equation. It might so happen
that an increased level of investment may lead to a decline in the marginal
efficiency of capital, which in turn will depress the instantaneous rate of
profit even on the face of increasing levels of output. In such a case the
slope of the above equation will be negative. In other cases it will be
positive.
In the Keynesian economy a negatively sloped LM-curve is in
conformity with a positively sloped IS-curve, explained earlier. A
negatively sloped LM-curve in the Keynesian system would imply a
positive coefficient for the rate of interest in the equilibrium equation of
the monetary sector. Small decrements in the rate of interest would bring
about a large demand for investment capital. The exogenously de-
termined money supply will then lag behind the demand for cash
balances, and a monetary equilibrium will be thwarted. Now, to restore
equilibrium, the monetary authorities would increase demand for
investment capital and thereby bring the demand for cash balances in
equality with the supply of liquidity.
In the Islamic macroeconomic order the above type of a dis-
equilibrium situation cannot occur, because the supply of money is
always constrained by an ex-ante demand for cash balances. Increasing
levels of output, while they bring prospects for higher rates of profits, will
in turn step up the demand for investment capital. The Islamic Central
Bank reacting to the improved level of profit, will have added incentive in
profit-sharing with entrepreneurs. This will, in turn, step up the supply of
liquidity to satisfy the demand for cash balances for investment
purposes. Shifts in the supply curve of money are caused by exogenous

variations in the monetary reserve variable by buying or selling securities
in an Islamic capital market in accordance with the requirements of an
easier or a tighter money supply.
Equilibrium in Terms of Real Values
So far we have discussed the equilibrium conditions of the expenditure

and monetary sectors in nominal values. We shall investigate now what
changes can occur in the price level. This leads us to investigate the
properties of the Islamic macroeconomic system in real values.
In this regard we shall first look at the monetary sector equilibrium. In
general in any economy with the rate of interest, if the expected demand
for cash balances remains unsatisfied it creates recessionary pressures in
the economy. The economy remains below the potential rate of growth
and the underutilisation of production capacity puts upward pressure on
the cost of production. Consequently, market prices of goods and
services rise. On the other hand, if supply exceeds the demand for money
there will be inflationary pressures in the economy, for now there is too
much money around. However, producers decide to cut back on pro-
duction capacity, and investments are subsequently not forthcoming.
Incomes rise, but not due to the force of labour productivity or
technological advance, but rather due to the supply effect of money on
prices and incomes.
In the Islamic economy, with interest rates being absent, the speculat-
ive demand for cash balances is non-existent. Consequently it is easier for
the monetary authorities to bridge the gap between the ex-ante demand
for cash balances and the supply of liquidity, given the reserves of the
central banks. The effect of this continuous monitoring of money supply
with expected demand for money to sustain monetary equilibrium,
arrests the problem of cost-push inflation in an Islamic economy.
However, as pointed out earlier, there will be times of excess demand
for investments in an Islamic economy. This will lead to an increase in
money income, with the marginal propensity to spend being higher than
can be affordable under the given schedule of aggregate demand (higher
than unity). A demand-pull inflation would thereby set in. This would,
however, be a temporary phenomenon, for a policy of distributing
increasing levels of profits in the form of cash dividends will finally
satisfy the demand for investment capital, thereby restoring the monet-
ary sector equilibrium. 18
182 Macroeconomics
These properties of the Islamic economy would rule out the possibility
of sustained increases in the price level for long periods of time. It is
known that only sustained movements in the price level can affect the
real values of a macroeconomic equilibrium. Therefore, in an Islamic
economy the usual macroeconomic relations will not be dynamically
altered by introducing the variables in their real form.
The Product and Labour Market Equilibrium
We have finally to investigate the product and labour market equilib-

rium in the Islamic macroeconomic order. Since price changes are not of
a sustained nature in the Islamic economy, the conversion of nominal
values into real values is not relevant. We shall therefore continue to
discuss the product and labour market sectors in terms of nominal values
only.
It may be recalled that the introduction of zakah was found to reduce
the aggregate as well as the structural forms of unemployment in an
Islamic economy, both through a specific application of the zakah fund
and through levels of output and capital expenditure into real invest-
ments. On the supply side the augmentation of training and income
supplementation by the zakah fund increases the labour participation of
target groups of workers. The labour force participation is expected to
increase with an increase in the dispensation of zakah to training and
income supplementation programmes. 19 Furthermore, the amount of
zakah is a positive function of income and profit. Therefore, through this,
both the demand and supply of aggregate as well as specific types of
labour are expected to be positive functions of income and profit. These
considerations yield the following types of specifications for the Islamic
product and factor markets.
The production function is given by f,
Y=f(K,L), (21)
where K denotes capital input. In the Islamic economy the capital stock
cannot be constant as in the Keynesian short-run production function,20
because of the high propensity to invest whereby capital is continuously
converted into real investment.
L denotes labour input.
Furthermore, co-operative conditions in the Islamic economy necess-
itates the fixation of the marginal rate of substitution of labour by
capital. We therefore take this in the constrained form

dK
- dL =m, (22)
where m is a parameter taking positive values. Its optimal value is

determined by equilibrium levels of wages and profit.
To relate the rate of profit to the marginal efficiency of investment we
take,
fJY/fJK = P. (23)
The labour demand function is given by LD
LD = LD(W,Y,I,Z). (24)
As usual this is expected to be homogeneous of degree zero.
The supply function is given by Ls
Ls = Ls(W,Z). (25)
The variables Yand I, affecting mainly the demand side of labour, are not
expected to affect the supply side.
In a labour market equilibrium we would have
(26)
Given Y, I, Z, this equation would determine the equilibrium wage rate
Woo The expression also indicates that zakah has a definite role to play in
wage determination as well. Note that we have not used the marginal
productivity theory to determine equilibrium wages.
We have thus completed establishing an equilibrium set of relations in
the monetary, expenditure, product and employment sectors of an
Islamic macroeconomic order. With these relations we can now
formulate the general equilibrium relations of the Islamic economy.21
GENERAL EQUILIBRIUM RELATIONS IN THE ISLAMIC

MACROECONOMIC ORDER
The general equilibrium relations in the Islamic macroeconomic order

can be explained in terms of the diagrams in Figure 11.2. Diagram I
shows the determination of the equilibrium output and profit rate
through the I IS and I LM schedules. Diagram II shows that, correspond-
ing to an equilibrium level of profit rate po, there is an equilibrium level
of capital stock K O, determined through the marginal efficiency of capital
00
~
p p
-
ILM
pO pO
Diagram I
KO yO
~---~----------K ~---------+----Y
w w Ls w
WO WO WO
Diagram IV
Lo
Diagram III
Lo
Lg LO L
L _ _ _ _ _ _..J''---S_ _ _ _ _ I yO Y,I,Z
5 ------
FIGURE 11.2 Macroeconomic general equilibrium system of the Islamic economy
schedule, given by equation (23). Diagram III shows that corresponding

to an equilibrium level of output yO, and given the values of I and Z there
is an equilibrium level of wages WO, determined by the intersection of the
labour demand curve L D , and the labour supply curve L •. Diagram IV
shows that corresponding to an equilibrium level of wages WO, given
values of yO and Z, there is an equilibrium supply of labour L?
Diagram v shows that, corresponding to the level of equilibrium
wage WO and yO, I and Z, there is an equilibrium demand for labour Lg.
The complete general equilibrium relations of the Islamic macroe-
conomic order are described by the following set of equations:
lIS Schedule
Y = A o +A I P+A 2 GO , (27)
where Y denotes national income or output,
P denotes profit rate,
Go denotes other autonomous government expenditure,
Ao, AI, A2 are constants.
ILM Schedule
P = B o +B I Y+B 2 R, (28)
where R denotes monetary reserves and is exogenously set

BoB I , B are constants.
Product Market
Y=f(K,L), (29)
where K denotes the capital stock,
L denotes the labour input,
f ( .. ) denotes the production function.
Factor Markets
Demand function for labour LD

LD = LD (W, Y, I, Z), (30)
186 Macroeconomics
where W denotes the wage rate,

I denotes investment,
Z denotes amount of zakah,
supply function of labour L.
L. = L.(W, Z). (31)
Wage Determination
Equilibrium level of wage is determined by the relationship

LD = L •. (32)
Equations 27, 28, 29, 30 and 32 comprise the general equilibrium
relations of an Islamic macroeconomic system. It has five equations in
five unknowns, Y, P, L D , K, W. The Islamic macroeconomic system is
therefore uniquely determinate.
CONCLUSION
The macroeconomic formulation of the Islamic economic order

attempted in this chapter shows that the elimination of the rate of
interest and its substitution by the rate of profit in the framework of an
Islamic profit-sharing mechanism changes many of the conventional
concepts of macroeconomic theory. Particular among these is the
reconceptulisation of an Islamic IS and LM schedules in the Islamic
economy and the preponderant role of investible funds in the Islamic
economy as the source for its coherent working.
The second most important instrument of Islamic macroeconomics is
zakah, capital tax on wealth and savings charged from all well-to-do
Muslims as a given percentage. The infusion of the zakah component of
autonomous expenditure in the expenditure and product sectors of the
economy changes the forms of relationship between taxes and output in
this economic order. Zakah, although a wealth tax, is found to have a
multiplier effect on income and employment generation. The resultant
fiscal policies are non-inflationary.
While formalising the workings and models of the Islamic macro-
economic order due reference has been made to corresponding analysis
in the Keynesian macroeconomic theory. The similarities and departures
of the Islamic macroeconomic concepts from the other macroeconomic
concepts are pointed out.
Islamic economics, infant as it is today, has still a far way to go to build

up its comprehensive system. This chapter is only a preliminary
contribution to that vast potential of this infant discipline in the making,
the central issue of which is to design and implement the distribution of
resources for the attainment of social righteousness. The principles in
this regard are derived from the Quran and the Sunnah, the holy
scriptures of Muslims.
Part IV
Postscript
The main objective ofthis chapter is to lay the foundations of the development
of Islamic economics as a special study in social economics. The chapter is in
three parts. In Part 1 we point out the inability and problems of mainstream
economics to cope with the purely ethical aspects of social analysis. The chapter
then shows how the development of social economics as an economic theory
imbued with clear ethical directives can remould society for the Common Good
of mankind. In Part 2 of this chapter Islamic economics is shown to be a strong
case of a new paradigm of social economics. An evaluation of the current
directions in Islamic economic thought is made. It is then shown that a new and
more rigorous, consistent and logical approach to the ethical microeconomics of
Islam is needed in order to discover the essential basis of a theory of Islamic
economics. In Part 3 of this chapter an axiomatic general equilibrium welfare
analysis in Islamic perspectives is introduced and rigorously developed as a
foundation of the methodology towards an axiomatic development of Islamic
economic theory.
12 Towards a
Methodological
Development of
Islamic Economic Theory
Mankind is today faced with its most dismal social and economic
upheaval ever since the Second World War. The traditional economic
machinery has failed to grapple with the problems of unemployment,
poverty, squalor, inflation and stagnation that have for a long time now
cruelly invaded the peace of human societies. Nevertheless the gap
between the industrialised nations and the less-developed ones con-
tinues to widen, with little hope in store for any acceleration in resource
flows to the less-developed countries.
What has really happened in the economic machinery of the
establishment that not only has failed to arrest the surging problems, but
was responsible in the first place for the agonies of this human planet?
This chapter shows that the root cause 9f the failings in the economic
machinery has been the absence of ethical considerations in it. It is then
argued that economic theory and its consequent policy applications
must therefore be reformulated within an ethico-economic field. This is
the domain of social economics. Part 1 of this chapter points out the
need for ethical considerations in economic theory and then introduces a
formalisation of an ethico-economic field within the fold of social
economics. Part 2 of this chapter delineates a special economic system as
an example of a social economy. This is the Islamic economic system.
However, here too a critical investigation shows that the trends in the
development of Islamic economics have not been conducive for the
development of Islamic economic theory. Part 3 of this chapter lays
down certain prescriptions for the logical and scientific development of
Islamic economic theory. An ethico-microeconomic general equilibrium
field is analysed and is subsequently developed into the macroeconomic
social welfare analysis of the Islamic economy.
191
192 Postscript
Part 1
Importance of the Ethical

Dimensions in Economic Theory
To start ofT our ethical economic thesis in this chapter a few examples
will suffice to point out the important relevance of ethical considerations
in economic theory: during the 1950s and the I 960s the developed as well
as the developing countries were being swayed by economic planners on
the prescriptions of neo-classical growthmanship. A few examples will
suffice to prove our point that the economic prescriptions were
incorrectly made. Two such prescriptive models were the Harrod-
Domar model of economic growth and Rostow's linear stages model.
According to the Harrod -Domar model economic growth was based on
the attainment of the right quantity and mixture of savings, investment
and foreign aid. Third World countries were therefore being asked to
follow a long-run economic growth path, emulating the pattern of
growth of the developed economies. In Rostow's linear stages model,
optimisation of savings and investment was considered as the principal
instrument of economic growth for the Third World. It turned out that
the mobilisation of capital through savings and investment took the
form of massive and expensive transfer of technology from the
industrialised countries to the developing ones.
The Harrod -Domar model of economic growth and Rostow's linear
stages model prescribe the same improper programme of industrial
development for the developing countries. That is, industrialisation was
to be mobilised with the aim of constantly saving an ever-increasing
percentage of the gross national product (GNP) for reinvestment. It is
then argued that investment in tum would reinforce the process of
capital accumulation through attainment of the desired levels of the
output/capital ratio. On the other hand, the greater goals of
economic development to reduce poverty, unemployment, income
inequality and so on, were considered exogenous to the formulas
prescribed. 1
The neo-classical paradigm continues to pervade the social insti-
tutions. Recently the World Bank's Program of Accelerated
Towards a Methodological Development 193
Development in the Sub-Saharan Africa is an example of the interplay

of the neo-classical paradigm prescribing a laissez-faire approach to
industrial development in SSA. It stands for a readaptation of the neo-
classical notion of an efficiency-oriented equilibrium model of economic
growth. 2
On theoretical grounds it has been seen that the neo-classical and the
Keynesian economic thinking on the Welfare State have met with grave
problems. Problems arise because of the contradictions between the
concepts of economic efficiency and social welfare. Unlike the neo-
classical prescription of a free market economy and perfect competition,
generating into economic efficiency, the prescription of the Welfare
State is based on a greater role of the government in resource
allocation. 3 The demise of the Welfare State in the industrialised
countries owes much to the Keynesian economic influence that the state
must increasingly intervene to monitor the ever-present inflation
employment trade-off. The Welfare State as Friedman argues is also
immoral as it provides disincentive to work, a propensity to leisure and
'welfare trap' for the low-income earners. 4 The Welfare State is also
found to have reinforced the already existing segmentation of the labour
market between the primary and secondary workers. An instance of this
is the French Commissariat au Plan, which in fact recommended a dual
economic set-up. One sector would be the competitive innovative sector
with a large amount of government protection. The other would be a
traditional sector requiring less government protection. 5
Finally, the whole neo-classical idea of the Welfare State was based on
a consumption oriented society. The consumption bundle was being
defined not only in terms of goods and incomes, but also in terms of
leisure. The alternative to employment in this model was leisure.
Empirical evidence shows that this trade-off between work and non-
work in the welfare model adopted by the industrialised countries is
nowhere to end in the near future, as these countries have come to accept
the final disappearance of the notion of full employment and as they
continue to grapple with the mounting cost of inflation, unemployment,
low productivity and growth. 6
Further studying the nature of the Welfare State in the developed and
the developing countries, we also find the neo-Keynesian economic
developments in this area to be embedded in the current tempo of the
North-South relations. Louis Emmerij interprets the basic needs
approach to economic development as a replay of the Welfare State
paradigm for the Third World. The consequence of this is the
intensifying social differentiation working in favour ofthe urban middle
194 Postscript
classes at the expense of the rural populations in the developing

countries. The fact is that the capitalists benefited from the low-cost
labour and unequal redistribution of income that followed a basic needs
approach to employment and development. The basic needs approach
to development is also relatively an inward-looking one. Because under
this approach to development the less-developed countries would
require accelerated flow of resources from the North to the South to
supplement an inward-looking prescription of growth. However, the
North and the South are presently lost in a deadlock with respect to
the future flow of resources. 7 The problems, therefore, appear to be
deeper than merely an economic one. They are essentially of an ethical
nature.
In summary to this section it can be said that the real cause of the
social and economic problems of mankind today are much more of an
ethical nature, calling for a solution within a rational approach to ethical
thinking within economic theory and policy. Neither neo-classical
economics nor Keynesian economics treats ethical considerations as
endogenous to economic analysis. The economic problem of social
welfare analysis is one of choice. Yet, food, clothes and consumption
form only a small part of the wider range of alternatives open to
individuals in order to reach optimum social welfare. Such choices are
often controlled by non-market forces. Yet they must be brought within
the purview of social welfare analysis, so as to explain not only what the
economic causes of welfare are, but also what causes welfare in this
complete sense.
FROM MAINSTREAM ECONOMICS TO SOCIAL ECONOMICS
Fortunately it is possible today to look into a rational reformulation of

economic theory and policy from a holistic, ameliorative and value-
oriented viewpoint. This is the goal of social economics as opposed to
the goal of mainstream economics, which adopts the approach of the
natural sciences of addressing itself to man's economic needs alone. 8
Social economics has been slightly differently viewed by different
economists during the process of its development. The underpinnings
are deeply rooted in the dichotomy between the concepts of the natural
law and the positive law. This can be traced in the economic thought of
Quesnay, who clearly differentiated between these two systems of laws
working in the economic system. 9 Schumpeter defines the concept of the
'natural law' as the 'awareness of the presence of a set of inter-related
phenomena that give rise to "problems" for social analysis'. The premiss
of the natural law is religion, philosophy, jurisprudence and intuition.
The positive law merely reinforced the declaration of the natural law. It
took the form of tools of mathematics, logic and the deductive and
policy sciences. 10 Later on Walras viewed social economics as a field of
inquiry intermediate between social ethics and economics. In this sense
social economics is a rational socioeconomic study of the application of
religious thought to the economic, political and social domain, calling
for applied judgements and reforms'.l1 Tawney saw social economics as
the means of studying society as being 'guided by a just appreciation of
spiritual ends, in so far as it used its material resources to promote the
dignity and refinement of the individual human beings who compose
it'.12 McKee defines social economics as an 'economic inquiry that is
both related in values and ready to take account of social aspects and
consequences of behaviour extending beyond what is usually under-
stood as economic'. 13
The methodology of social economics can be well summarised in the
words of John C. O'Brien: 'The new paradigm would emphasize the
importance of the public interest, the idea of community. It would place
particular importance not only on man's quest for material progress but
also for that ethical progress without which man's material progress
cannot even be preserved. Social economists would have no compunc-
tion, therefore, about making normative judgements in keeping with the
traditional code of morality. Ethical considerations would not be
excluded from the study of economic problems'.14
Now, if this trend in economic theory is made to bear upon
mainstream economics, what would result is a new approach to
economic analysis that comprehends a much wider area of social welfare
analysis than the neo-classical value-neutral basis of utilitarianism. A
new concept of social contract in the exchange mechanism would result.
The concept of economic efficiency will change. The patterns of
consumption and production menus, of income distribution, resource
allocation and product pricing will all change. A new methodological
approach would therefore have to be evolved and a different set of
economic objectives maximised in order to treat the ethico-economic
problems of microeconomics and macroeconomics consistently and
rationally.
When economic theory is viewed in these ethical but consistent
perspectives, the narrow prescriptions such as those of the Harrod-
Domar model of economic growth and Rostow's linear stages model
earlier referred to breakdown, because now the composition of the GNP,
196 Postscript
and the way it is generated and distributed, changes. Hence, the concept
of general equilibrium analysis changes too.
In order to make GNP a better reflection of the social welfare,
Nordhaus and Tobin have expanded the computation of GNP to include
the value of consumption goods, investment and intermediate goods,
value imputation for the services of consumer capital, for leisure, time
spent in household activity and for externalities. 1S Greenberg shows
that with this extended measure of GNP, the estimate of the aggregate
output would have to be determined as a weighted aggregate of outputs
generated in various sub-systems, some of which produce pure econ-
omic goods and services, some produce non-market activities and others
produce externalities. 16
If the different bundles of consumptions can be weighted according to
different consumer groups, say with the poor receiving a higher weight
for the same unit of consumption, and if subsequently the corresponding
investment menus producing the consumption goods and services can
also be suitably specified, then the general equilibrium problem would
take the form of an interrelated objective of maximising the social
welfare function subject to the production menus and other resource
constraints. 17
In the new paradigm of social welfare, greater resources would be seen
to be available for augmenting employment while not escalating
inflation, and this would be realised by a greater sense of work-sharing
and worker solidarity. A reorganisation of the consumption and
investment menus for socially productive goods and services will reduce
the unwanted onslaught of microcomputers and technologies on
structural unemployment. Ivan Illich characterises the unfortunate
situation as the effect of 'the cult of professionalism, the presentation of
the radical monopolies of disabling professions and the central place of
the concept of economic competitiveness'.1s
The new paradigm of the social welfare model for the Third WorId
will emphasise a co-operative socioeconomic model of development as
opposed to a purely competitive equilibrium model. It would seek to
optimise the efficiency-equity conditions within the milieu of a self-
reliant integrated development of the South. In this approach, human
resource development, production of proper types of goods and
services, expansion of complementary product needs, attainment of
his/her employment and productivity, increased incomes and price
stabilisation, and inter-<:ommunal transfer of technology, will lay down
the path to total welfare. 19 Such an idea is opposed to the dependency
model projected by the prevailing North-South economic relations. 20
SOCIAL ECONOMIC PERSPECTIVES OF REFORMULATING

ECONOMIC THEORY
Social economics, therefore, involves a serious reformulation of econ-

omic theory in the mould of ethical considerations. The reformulation
would have to start by tracking down the entire gamut of the traditional
economic assumptions, systems, scope and methodology. The begin-
ning point would be to reformulate the concept of economic rationality
not in terms of maximising individual ethics-neutral hedonistic types of
utility functions, but rather in terms of economic co-operation among
individuals and communities. Economic efficiency will have to be recast
not in terms of perfect competition, but rather in terms of conditions of
co-operation within a competitive market model. 21 Consumer sov-
ereignty and the pure profitability criterion of producing and consum-
ing goods and services would have to be replaced by the idea of social
goods and services; that is, goods and services that are not only socially
shared, but also generate social profitability and consumption/produc-
tion externalities. 22 The pricing of the product, cost and benefit
specifications, resource allocation and choice of production menus
would all have to be determined under competitive-co-operative
conditions rather than under purely perfect competition. Utility and
output maximisation would have to be reoriented to interdependent
altruistic consumption patterns with external benefits and to dif-
ferentiated menus of output. Marginal analysis will have to be replaced
by average productivity analysis. Indeed average productivity would
have a better approximation of income distribution across the popu-
lation than the measure of marginal productivity of labour, which
denotes the results of undifferentiated self-interest and self-
motivation. 23 In this way the role of X-efficiencies in welfare maximis-
ation will playa singularly more important role than sheer allocative
efficiencies. Welfare economics and welfare maximisation will have to be
figured out in terms of the optimal attainment of certain social
objectives, such as full employment, price stabilisation, economic
growth and socioeconomic development goals (income distribution,
alleviation of poverty, squalor, etc.).24 The Walrasian form of general
equilibrium that caters for multimarket general equilibrium based on
relative prices of consumer goods is inappropriate in explaining general
equilibrium as an ethical economic system. The reason being that prices
are derived from the basis of Benthamite type utility functions. Besides,
under ethical considerations on joint consumption, externalities in
production and altruistic co-operation, excess demand could remain
198 Postscript
strictly negative in all markets. Yet the supply price will not be
necessarily zero in all markets.
On the macroeconomic side, too, the microeconomic foundations of
price, income and employment analysis and of dynamic socioeconomic
development theory will have to be the building blocks. This would
differ from the usual institutional form of aggregate analysis. In this new
approach, on the macroeconomic side the consumption function, the
investment function, the production function, fiscal and monetary
considerations required to monitor employment, stability, growth and
socioeconomic development, must all be weighted average aggregation
of the processes going on at the microeconomic level. One approach
towards this reorientation of general macroeconomic equilibrium is to
specify a social welfare maximisation problem based on the attainment
of the critical social objectives, such as employment maximisation, price
and incomes stability, economic growth and socioeconomic develop-
ment as these emanate from ethico-economic considerations in the
social consumption, investment and production menus. The constraints
of this optimisation problem will be the lateral aggregation of mic-
roeconomic consumption functions, of the firms investment functions
and production functions, along with the aggregate resource con-
straints. The monetary and fiscal systems would be treated exogenous to
the system, being instruments essentially required to gear the system to
its desired equilibrium in consumption and production.
These new dimensions in economic theory suggest that the ethical
approach to economic analysis would still have to keep the discipline of
economics as a self-contained whole in itself. Otherwise the encroach-
ment of foreign elements in economic theory such as through religion,
philosophy, sociology, value judgements, etc., can destroy the fabric of
any self-consistent and well-defined domain of economic analysis as a
science. The need for standardising certain assumptions for internal
consistency of the economic system would be fundamental. Otherwise
the study of ethical economies will be drifted away from its scientific
moorings. Next will come the great importance of methodology in this
scientific discipline. There is no doubt that the mathematical approach
to economic theory has given to this discipline a vast predictive power
and analytical precision. In the new system of social economics, too, the
mathematical and statistical tools will have to play the major role for
analysing in an integrated way the interrelated systems of economic and
ethical elements of the whole. Finally the development of the new
approach to economic theory must proceed along some systematic lines.
Since microeconomics would provide the logical building block of the
macroeconomic system in social economics, the proper direction of

development for social economic theory would be the reformulation of
microeconomics in the first place. This can be gradually and logically
extended to the field of a new macroeconomics.
Social economics, therefore, does not have to dismantle the highly
advanced logical structure of mainstream economics. What it has as a
challenge is the reformulation of many of the fundamental assumptions
of mainstream economics necessitated by the integrated treatment in the
economic system of both economic and ethical elements. Next it must
develop up its own analytical systems to explain the economic relation-
ships in the ethico-economic system.
Part 2
From Social Economics to Islamic

Economics
An example of an emerging economic system, one that is value-oriented

and capable of formulating a consistent, rational analysis of the ethico-
economic system is Islamic economics. To summarise, the core of
Islamic economics consists of the overriding importance of ethical
considerations in the economic system. Naqvi asserts that in the Islamic
system of economics it is ethics, 'independent of the economic con-
ditions prevailing at any time or in any society, that must guide human
behaviour for the attainment of social bliss as well as spiritual salvation'.
The social bliss is explained by Naqvi to mean both economic
betterment and spiritual ascension as two elements of a unitary Islamic
outlook on what constitutes human happiness. 25
Islamic economic doctrine thus lays the foundations of a non-homo
economicus society in which individuals would interact and social
relationships would be established on the basis of ethical dealings
thoroughly pervading the realm of economics. The ethical dealings on
which Islamic economic behaviour are founded are again not arbitrary
in nature. Ethical norms are generated not by majority action on the
principle of voting on a given ethical issue (such as society's consensus
on abortion, poverty, humanistic education, etc.); rather they are
200 Postscript
founded fixedly on the principles of the Quran and the traditions of the
Prophet Muhammad. Then these principles are further extended by
analogy but without drifting away from the devine moorings of the
original Islamic sources (Quran and traditions of the Prophet
Muhammad). In this way both the individual and societal norms of
conduct, decisions and functions are given unique and definitive
directions. The degree of arbitrariness in ethical matters is thereby
reduced to a matter of difference in interpretation by the doctors of
Islamic law and divinity.
The fundamentals of Islamic ethical behaviour, however, remain
unique and well defined. That is, man must augment his pure economic
actions and preferences by the preferences and actions enunciated on the
basis of the basic Quranic laws. Hence, for every individual action in the
mundane world there is a reciprocal reward in the next world and a
quantifiable equivalence of that Islamic action today. Man, by accepting
this collateral action of the purely economic with the Islamic ethical
preferences and actions, establishes what are known as taqwa or God-
consciousness and ibadah or worship.26 These two fundamental ele-
ments of individual Islamic behaviour in social dealings become the
cornerstone of Islamic ethics in economics. When these elements of
individual behaviour are fully understood at the microeconomic level,
and are fully mobilised by certain basic micro- and macroeconomic
instruments peculiar to the Islamic economy, then an integrated general
equilibrium Islamic system can be formulated. It is thereafter neither
necessary nor sufficient for establishing an Islamic economy to exercise
any more complicated interpretations of the Islamic law, found to be
debatable among different Islamic schools of thought, or to deliberate
upon the corresponding operative instruments involved. The basic
operative instruments that must be focused on are the abolition of riba
or the Islamic concept of interest on capital; tbe replacement of riba by
mutJarabah or profit-sharing (also musharakah meaning both profit- and
loss-sharing) between partners in an enterprise; the mandatory payment
of zakah or the Islamic quasi wealth tax for purely income and wealth
distributive purposes, and the abolition of israf or wasteful consump-
tion. 27 Beyond this all other particularities such as the indecisive Islamic
scholastic views on the pricing of risk, hire-purchase, mark-up in
tradeable goods, forward pricing of goods, the time-preference theory,
the determination of a normal rate of profit, the extent of monetary and
fiscal leverage acquirable by the Islamic state, the issue of residual
taxation over and above zakah, are mere matters of detail. They
contribute nothing significant to the development of Islamic economic
theory. They may therefore be left out from purely theoretical consider-
ations and assigned their specific policy controversies.
CONTEMPORARY TRENDS IN THE DEVELOPMENT OF

ISLAMIC ECONOMICS
This latter point, explaining the dichotomy between Islamic economic

theory and policy, is a fundamental issue to note in the development of
an Islamic economic theory and analysis. As it stands today, Islamic
economics does not have a body-theoretic foundation, and because of
this vacuum it has not advanced with the same tempo and vigour of
modern economics. What the Muslim economists have today are the
rudiments of certain principles of Islamic behaviour and public policy
derived from the glorious works of the past and worked upon by some
contemporary Islamic scholars to give them more analytical meaning in
the jargon of mainstream economics. These works, of course, do provide
certain important guidelines and normative principles of Islamic
behaviour for the Islamic individual and the state. But they can hardly
be considered as providing a sufficiently established, internally con-
sistent and logical development of the discipline of economic theory.
A few examples on the contemporary terrain of Islamic economics
writings and deliberations will suffice to show that the directions of
development in this area is not conducive to the formulation of Islamic
economic theory.l8 The overriding concentration of contemporary
works in Islamic economics has been in the area of monetary theory and
public policy. Here, too, priorities of research have been placed on such
topics as the institutional aspects of Islamic banks in creating and
controlling money supply; the Islamic financial instruments available to
the Islamic banks; elements of monetary policy in an Islamic state; an
evaluation of interest-free banking in practice. l9 Papers presented at the
recent international Islamic economics conferences have also continued
to concentrate on the monetary and fiscal economics aspects. Even when
topics such as profit-sharing and resource allocation were discussed, the
central concern was with the functions of the Islamic banks in the
economy, and on the primary concern in developing an instrument that
would replace the rate of interest in an Islamic economy. Let us examine
a few examples of such trends in contemporary works in Islamic
economics.
The work by Abu Saud on Islamic money and banking is a
mechanistic description of money, loan, interest and profit-sharing in a
202 Postscript
comparative Islamic framework. Considerations of pure Islamic law

and jurisprudence in this work tend to blur it from any significant
economic theoretic value. 30
The work of Uzair, one of the pioneers of interest-free banking, is
again a mechanistic description of the operation of interest-free
bankingY This work may have had done better by analysing a viable
Islamic financing method for short-term loans and consumer credit.
However, very simplistic solutions of the average rate of return
criterion, and the minimising of consumer credit demand by a process of
elimination based on religious and sociological grounds, make the study
uninteresting to the theorist.
Then there is a recent work by Siddiqui on Islamic money and
banking. Nienhaus, commenting on Siddiqui's work, finds it to be more
of historical value than of analytical value. Although the work does
open up thinking on pure profit-oriented PLS banks, and discusses
macroeconomic policies to monitor such institutions, the model
Siddiqui proposes is not an analytical one. The 'text is more descriptive
than analytical, somewhat lengthy and [that] arguments are often rather
mechanistic'. Nienhaus thus sums up by commenting that 'Banking
Without Interest is neither a textbook nor an introduction into present-
day Islamic banking, and it cannot represent the actual state of research
in monetary Islamic economics'. 32
Khaf's book, The Islamic Economy, is again a better accomplishment
on the monetary aspects of Islamic economics rather than on the
microeconomic aspects. His attempt to theorise a consumption be-
haviour for the household in an Islamic economy does not lay down an
analytical basis for consumer theory and demand theory that could then
be integrated with the theory of the firm. Even on the monetary aspect of
his work the categorical comment by the author that 'zakah would help
divert every bit of wealth into productive activity', can only be true if,
(a) zakah fund is used over a longer period of time than a period of one
year. But this would then contradict established understanding. among
Islamic scholars that zakah must be spent within a year. (b) The
disbursement of zakah increases current consumption. This, therefore,
may not directly increase productive activity. In other words, the
principal objective of zakah disbursement is mere redistribution and
transfer income. On the other hand, it is the interest-free nature of the
Islamic economy rather than zakah that can be assigned this direct role
of converting savings into real investments. 33
Zarqa's work on the social welfare function is too rudimentary to be
of any analytical or quantitative importance to the development of an
Islamic welfare economic theory. Issues on the formation of social

ordering in an Islamic framework, the assumptions of Islamic ratio-
nality or internal consistency of social welfare decisions, the formulation
of a general equilibrium framework of welfare economics and a host of
related issues of welfare economics in Islamic perspectives are not
treated. 34
Professor Naqvi's book, Ethics and Economics: An Islamic Synthesis,
is a closer attempt at laying down the ethical axiomatic foundations of
an Islamic system, and then to show that his Unitary Axiom translates
into non-wasteful and constrained type of consumer preferences and
commodity universe. 35 The utility functions are treated to be inter-
dependent among consumers. Naqvi's Equilibrium Axiom introduces
the novel idea of maximising the total welfare in an Islamic society and
not merely the marginal welfare. He then argues that under this
formulation the marginal social significance of each individual in an
Islamic society would be the same. This in tum implies that there would
be overall equality in the marginal distribution of income in society.
Naqvi's Free-Will Axiom leads to a certain type of dual economic
setting, where both competition in a free market will prevail as well as
considerable government intervention to monitor social policies for the
common good. Naqvi's Responsibility Axiom translates into income
transfer by the state for income redistribution purposes and to the
ethical readiness of the individual in upholding this necessary transfer
process. Likewise, such a transfer process is shown to constrain the
consumption mode of the individual and to establish a just share
between labour and owners of capital based on wages that are fixed in
advance but on profits being shared ex-post. The contribution made by
Professor Naqvi is laudable in that it lays down certain substantive
grounds for the building up of a microeconomic content of Islamic
economics, and hence to develop the Islamic macroeconomic theory.
However, the work is thoroughly descriptive, and instead of further
developing the analytical depths of the ethical economic system that he
postulates, Naqvi goes on to discuss policy issues and instruments of an
Islamic economy. Here the work meets with less originality, for the
principal policy objectives prescribed by Naqvi for an Islamic economy,
such as social justice (income distribution, equality of opportunities,
universal education, basic social welfare), economic growth and income
generation are well known in modem welfare economic jargon.
Some contemporary Islamic economists have also strayed away in
their attempt to formulate an Islamic concept of economic development.
The works here by Ahmed, Sharif and others are too descriptive to be of
204 Postscript
any analytical value to economic theory.36 Ahmed's delineation of the

concept of development in Islam is tantamount to a social welfare
approach to development with certain fundamental Islamic ethical
elements. In as far as these ethical elements of social welfare translate
themselves into balanced growth, income distribution, social equity,
basic needs, employment and elimination of poverty, there is no
difference between the Islamic and other approaches to economic
development. This is why we find that Ahmed's prescriptions for the
goals of development policy in Islamic perspectives are no different from
those usually prescribed in a modem textbook in development econ-
omics. 37 The contributions of these works on the pure theory of
development in Islamic perspectives remain inadequate.
Mannan has gone to the extent of recommending that economic
policy in Islamic perspective be considered as an integral part of Islamic
economics as a science. He also suggests that the starting-point of
developing Islamic economics as a science must be to identify an issue
and a problem and then to trace out the guiding principles on the basis of
shariah (Islamic law).38 There are two fundamental methodological
difficulties in the approach to scientific Islamic economics suggested by
Mannan. First, the aim of Islamic economics as a theory and analysis
must be essentially to delineate and structure a logical, internally
consistent, ethically oriented system of economics that will explain both
the microeconomic and the macroeconomic equilibria of the basic
economic activities, consumption and production, market and firm,
interdependent exchange and welfare, resource allocation and growth.
It is not at all necessary for theory to formulate a policy. Second, while it
is true that in Islamic economic theory the problem of ethics and
economics will be cast in the shariah mould, this should be limited to the
principal aspects of the Islamic law that can suffice to impart the
assumptions and functions of the Islamic economy. This can be done by
choosing only those areas where there is overall consensus among
Islamic schools. To go beyond this would limit the uniqueness of
assumptions and the rationality requirements for the development of a
scientific theory of Islamic economics.
The excessive focus given by trends in Islamic economics today on
topics like monetary and fiscal studies, policies, and some on economic
development, is the result of the observed immediate needs of con-
temporary institutions in the Islamic world, the problems of develop-
ment in the Islamic countries and the given stock of expertise among the
peers in Islamic economics. Since the early 1970s some large Islamic
institutions have grown up. Among these are the Organisation of
Islamic Conferences (OIC), the Islamic Development Bank (lOB), the

Islamic banks, Islamic holding companies and investment companies.
These institutions have created an effective demand for practical
thinking on Islamic economics and policy, but principally to cater for
their immediate development and financial problems as opposed to a
sustained long-term growth of basic research leading to a development
of a body-theoretic approach to Islamic economics.
Historical factors behind the emergence of the OIC and the lOB are
those which are common to many similar development finance insti-
tutions of the South. Bhagvati narrates these factors succinctly.
According to him the process of decolonisation that followed the post-
1960s created new nations of the South. These nations soon increasingly
started to feel that their voting powers in the Bretton Woods institutions
had little weight, and that their interests were not served properly in the
deliberations of these institutions. The nations of the South thus felt
politically and economically more secure under the auspices of their own
institutions. The distance between the North and South become even
greater as 'rival philosophies appeared, accentuating the differences in
perception, prejudices and principles'. 39
Among the rival philosophies was the resurgence of the Islamic polity
of nations in the Islamic countries. This was further fired by the afHuence
of the oil boom in the capital-surplus Arab countries. The emergence of
the Islamic Development Bank and the Organisation of Islamic
Conferences owes as much also to these factors. It therefore aimed at
recycling the petro-dollars in the Arab states to mobilise the resources of
the Islamic countries for the common good, by utilising certain financial
instruments and modes of financing as recommended by Islamic law.
THE NEED FOR BIFURCATING THEORY FROM POLICY IN

THE DEVELOPMENT OF ISLAMIC ECONOMIC THEORY
Such immediate considerations by the Islamic institutions have created

conducive grounds for present-day Islamic economists to think on
immediate and related issues. But because of the overly policy oriented
nature of the approaches to the problems, the growth of Islamic
economic theory in its pure, logical and systematic form has not
blossomed.
In general the student of economic theory discovers in his serious
examination of the development of economic thought through the ages,
that policy issues which have been of a local and temporary type have
206 Postscript
not contributed to the development of economic theory. Economic

theory by and large developed independently of policy. This, of course,
does not mean that economic theory must be blind to the realities oflife.
Issues relating to tariffs and trade, monetary standards, labour markets,
business fluctuations, taxation and financial institutions would, of
course, have to be considered. But in the context of economic theory,
these are the products of a theoretical, systemic whole, and not vice
versa. They by themselves do not structure economic theory.40
This is why we find that the economic doctrines of the Physiocrats and
the Mercantilists have not affected economic theory to any significant
extent. Economic theory started in earnest with the advent of the
classical school and was then subsequently developed by the inscrutable
minds of Senior, Ricardo, Marshall, Leon Walras and the eminent
Austrian School, all the way to John Maynard Keynes. The principal
element in this great advance of economic theory was the scientific
investigation into the theory ofvalue. 41 The theory of value gave rise to
some of the great scientific advances in economics, such as the
understanding of the exchange and price mechanism in the market-
place; the interpretation of the cost of production as the value of
exchange; the theory of distribution; the theory of utility and social
welfare; the theory of resource allocation; and so on. These are issues
principally at the microeconomic level. Macroeconomic theory is more
recent. Keynes's General Theory is a landmark of great analytical work
explaining aggregate behaviour of critical economic indicators, such as
the propensity to consume and save, the marginal efficiency of
investment, the under-full-employment equilibrium in the labour
market, the motives of holding money and the distribution of income.
Keynes was influenced not by local policy issues when he formulated his
theory; rather his General Theory rides on the crest of pervasive events
in history. These were the concerns with distribution of national output,
the stability of the price level and the integrated study of the factors,
product and money markets. 42 One can note here the words of Stigler,
who finds that 'only general and persistent policy questions are likely to
call forth permanent advances in the theory. The unending train of
ephemeral or local policy questions is of no more significance for
economic theory than the corresponding types of economic
developments. 43
In Islamic economics the pressing need of the time for developing this
field of economic thought as a theory and analysis, is to structure out the
ethical-microeconomic foundations of a logical and consistent theory,
with the minimum number of assumptions confined to the fundamental
Islamic assumptions that are capable of transmitting the Islamic fervour

through the system. Such an ethical theory of economics must be
continuously influenced by ijtehad (Islamic authoritative research), but
must exclude policy issues of a more immediate, local and transient
nature. The microeconomic ethical foundations of Islamic economics
must then be made to shape the macroeconomic analysis. Within this
approach the issues of trade, co-operation, money and financial
institutions, etc., can then be studied as the logical by-product of the
basic theory.
Part 3
Towards a Scientific Formulation of Islamic

Economic Theory
An area of primary importance in Islamic economic theory would

therefore be Islamic welfare economics. One would first have to
carefully develop the axioms of a choice theoretic approach to
individual and social ordering based on the ethical principles of Islam.
The individual and social ordering must then be well defined in order to
explain certain definite structures of preferences. This is called 'complete
pre-ordering of social choices'. Then a viable social welfare function for
the Islamic economy must be developed. The function must be specified
and be capable of empirical estimation. The general equilibrium analysis
of the Islamic economy must be explained in terms of this social welfare
analysis with ethical foundations. The analysis of the problems of
money, employment, distribution, development, trade, co-operation,
financial institutions, etc., can then evolve out of this ethical social-
welfare-oriented general equilibrium system. 44
A definition ofIslamic economic theory can then be possible. It can be
defined as the sum total of the historical, theoretical and empirical
studies that analyse the human and societal wants in the light of an
integrated value system. The two subsets of this value system are: (a) the
marketable goods and services, their consumption and production,
208 Postscript
along with their prices; (b) the augmentation ofthese economic activities
by Islamic ethical values affecting consumption, production and other
related economic activities. The goal of the Islamic economic theory
would then be to develop an internally consistent and viable quantitative
general equilibrium system out of the integrated value system. To an
axiomatic formalisation of one such Islamic general equilibrium system
we now tum.
THE MICROECONOMIC FOUNDATIONS OF ISLAMIC

ECONOMIC THEORY
The microeconomic building block and its aggregation to macroeco-

nomic models is essentially the foundation of economic analysis in
Islamic perspectives. This is due to the fact that it is the individual's
ethical and economic behavioural patterns that can ultimately shape the
Islamic society. The role of the state is only to promote and monitor the
progressive Islamic transformation. This is quite unlike the case in the
Marxian and capitalistic economic systems. In the Marxian system the
state becomes the sole guardian of the individual. In the capitalistic
system ethical considerations either of the individual or the state are
minimal both in the consumption and production menus. The entire
working of the Islamic economy in a general equilibrium sense can then
be formalised by optimising a social welfare function with ethical
parameters, and with the major socioeconomic indicators -
consumption, output or growth, employment generation, income
distribution. In Islamic economic theory of social welfare the consump-
tion variable is important because of the social constraint of israf
(wasteful consumption). Output is important for indicating the pattern
and pace of growth, productivity distribution and adoption of appropri-
ate technology for the fullest utilisation of factors of production.
Employment generation and income distribution are the well-known
goals of social welfare. Income distribution would be affected by zakah
(Islamic quasi wealth tax) and a mudarabah-masharaka (profit- and-
loss-sharing) instrument. Price stability is not considered as a goal
because, in the absence of interest and a speculative demand for money,
and the presence of high levels of real investment, inflation will not be
sustained in an Islamic economy.
The Islamic microeconomic ethical foundations of a macroeconomic
system can now be shown to lead to a logical and consistent ethico-
economic general equilibrium system. To formalise this we shall first
specify an Islamic social welfare function based on its microeconomic
foundations. To do this we define the following three mathematical sets

with respect to the preference ordering relation defined on them and
given by ~ . This ordering relation is reflexive and transitive on the
corresponding sets. The reflexive condition is trivial. The transitive
relationship can be shown to exist in Islamic pre-ordering of social states
because within the trade-off between purely economic preferences and
ethical references the total preference can still be pre-ordered. 45
CHARACTERISATION OF THE CONSUMPTION SET46
The ith individual's consumption set is completely characterised by

C i = {Xi:Xi ;S xn, i = 1,2, ... , m.
When Xi - xi, C i denotes the indifference class of consumptions, Xi. The
relation xi:S xi denotes that individual consumption in the Islamic
consumption set must reach a satiation point denoted by xi.
The total consumption set is denoted by
C=
i
0= Ci ={(xi):(xi):S(xi)},i=I,2, ... ,m.
1
This means that C is the set of a sequence of consumptions denoted by

(x;), such that each element of the sequence (Xi) has its own preference
pre-ordering with respect to the relation :S, and each consumption
bundle is satiable. In an Islamic economy the sequence (Xi) must tend to a
limit (XO), possibly a minimum average consumption bundle. That is,
Xi ..... XO => (Xi) ..... (XO). Since (xo) is necessarily in C, therefore C is closed.
Conversely, too, since each XO e Ci , each C i is closed. Therefore,
C=
i
0= C
1
i is closed. 46 Since XO denotes a minimum average consump-
tion level of an individual and it belongs to the set Ci and C, so the
individual can always reorganise his possible consumptions to approxi-
mate to this average consumption level. Thus, C i and C are convex.
Clearly also Ci and C are closed and bounded, i.e. are compact. In
establishing the properties of the consumption sets the principle of La
israf (avoidance of consumption in prodigality) was used. At the same
time, by so constraining the consumption levels each individual is able to
approximate his consumption to the average consumption for society.
This is the Islamic criterion for equality in basic consumptions by all
individuals in society.
210 Postscript
CHARACTERISATION OF PRODUCTION SET
Next we turn to the formalisation on the production side. We define the

jth producers' production set by Pj' where
Pj = {Yj:yj c::: Yj c::: yj},j = 1,2, ... , n.
When Yj "" Yj, Pj defines the indifference class ofYj . In other words Yj
belongs to the same production isoquant. The relation Yj c::: Yj denotes
that the firms' productions must exceed a given output level so as to be
able to provide sufficiently for meeting the specific consumption needs of
society. After this basic social consumption is satisfied, additional output
is also required for building up inventory, distribution and then trade.
UnderutiIisation of capacity is thus ruled out. The reiationYj c::: Yj means
that, subject to constraints of resource availability technological change
and market demand specifications, the production level can be also
constrained.
The total production set is denoted by
P = 0 Pj = {(yJ: (yj) c::: (Yj) c::: (yj)}, j = 1,2, ... , n.

j;l
In an Islamic society individual as well as total demand must be satisfied,

through increased production, trade or through control of consumption
levels. Therefore there is a minimum average target yO e P j C P for each
firmj = 1,2 ... ,n, such thatYj ~Yo =
(Yj ) ~ (yO). Clearlyhere,Yjand
yO are measured in terms of efficiency units; such as capacity utilisation P j
and P are then seen to be closed and bounded (compact). Also by the
argument of a minimum average target production attainable in P j and P
as for consumptions in the case of Cj and C, all possible production levels
of the firms can be reorganised so as to approximate to this average
production level. Thus, Pj and P are convex.
CHARACTERISATION OF THE ETHICAL SET

In an ethical economic system both the consumption and the production
sets would be augmented by given ethical elements. In the Islamic
economic system the fundamental ethical considerations are the given
social sense of consumption, production, resource allocation and distri-
bution motivated by God-consciousness, social justice and iridividual
responsibility towards God and his fellow beings. Let then T denote the
ethical set, applicable both to the individual and the firm:
T = {(Z"J: (Z,,) ~ (Z~)} ,
where k spans over the ethical elements mentioned above, Z" denotes
certain ordinal index of the level of practice of the corresponding ethical
element k by the agents involved. Being ordinal in nature Z" need not be
quantifiable, but Tf. R' where k = 1,2, ... ,I. R' denotes the I-tuple set of
real numbers, i.e., the I-tuple real space. The pre-ordering ~ denotes that
the level of ethical heights achieved by the individual and society in the
Islamic system is unbounded. Only in extreme cases is it possible for the
individual or society to remain on an ethical indifference curve. This
happens, for example, when an individual practises only his basic
required Islamic duties, or the firm in order to divert outlays in zakah
alternates to productive investment, so that its level of ethical practice
surrounding zakah remains given, but this is compensated by increased
economic benefits through increased levels of productive investment.
Apart from this there may also be few segments of the population in an
Islamic society on whom the Islamic ethical elements have not had
sufficient effect. 4 7
EQUILIBRIUM IN THE CONSUMPTION AND PRODUCTION

SETS
In any ethical economic system the set Tmust qualify the sets C (therefore
Cj ), P (therefore Pj). We must therefore be able to clearly define a
continuous mapping, .0, from the set T to the set C (and Pl.
Let n: T-+C
Such that n (T) = C, i.e. in the ideal case the effect of the ethical elements
must be felt on every element of the consumption set C. Tis mapped on to
C. In the general case this restrictive condition can be relaxed by putting
n(T) = C' c C. Values of n(T) are multidimensional. For example,
both God-consciousness and social justice could influence an individual's
or society's preferences for consumption.
Let n«Z,,)f.T) = X;, V'xjf.C(or V'Xjf.C' C C),
k = 1,2, ... , I,
i = 1,2, ... , m.
212 Postscript
Since Xi =1= x. necessarily, so the correspondence is not unique.

However, Xi e C c IR m and Zk eTc IR', and Q (T) = C, where s < m.
Therefore IR' c IRm. Furthermore I < m since Islamic ethics in economics
may be kept to the basic fundamentals. Thus, IR' c IRm, and then clearly
there will be points Zae T, such that
Q((Za)eT) = Xa for some fixed ZaeT, xaeC.
In this case we find that Za e Tis a fixed point. However, because the set T
is not compact, this fixed-point result does not correspond to Brower's or
Kakutani's fixed points. 48 A compact consumption set is known to have
an equilibrium. It therefore follows that, given the existence of fixed
points in T as defined earlier, an ethico-consumption equilibrium exists.
Since an equilibrium point in the consumption set can be mapped on to
by any point in the ethical set; therefore the ethico-consumption
equilibrium is a global one.
The same arguments can be made and similar equilibrium results
derived with respect to the sets T and P. Let us denote the mapping now
by O.
0: T-+P,
such that = P.
0 (T)
Now O((Zk)eT) = Yj,YieP,
k = 1,2, ... , I
j = 1,2, ... , m
The correspondence 0 is again not unique and can assume multivalues in
the set P, where P c IRft, with 1 < n, and 0 (T) c IR', where t ~ n.
Therefore IR' c IRft. Now by the same arguments on the fixed points and
knowing that a compact production set has an equilibrium, it follows that
an ethico-production equilibrium exists. The same results applies also to
a subset pi of the production set P.
The correspondence between T, C and P can be demonstrated by
Figure 12.1. Their correspondences in the real spaces are also shown. The
set C' denotes a subset of the set C mapped on to by n, inside which the
ethico-consumption equilibria occur. The set C' can expand and
approximate to C, as the number of fixed points in T increases. If in the
limit there is a fixed point corresponding to each point in C', then C' = C
and C = C Ie Q (T). Similar arguments are extended to the sets P' and P.
Since T is an unbounded cone, the sets C' and P' have the possibility of
expanding continuously over time. So also for the sets C and P.
u·e
FIGURE 12.1 Ethico-economic equilibrium in the consumption and production

sets
GENERAL ETHICO-ECONOMIC EQUILIBRIUM:

SOCIAL WELFARE FUNCTION
Figure 12.1 furthermore suggests that the general equilibrium in the

ethico-economic plane is established by the joint existence of equilibria in
the ethico-consumption plane and the ethico-production plane. The
equilibrium between the consumption and production activities is now
required to complete the cycle in this chain of argument. This is quite
straightforward, for the excess demand «x) - (y)) < 0, and in the Islamic
economy, since (x - y) is monotonic, increasing or decreasing for xeC'
(or C) and yeP' (or P), therefore over time L\(x - y) < O. This is a
necessary condition for a stable equilibrium in consumption and
production. 49 A general equilibrium, therefore, exists for the ethico-
IX:onomic system in the Islamic order.
Now let us define a monotonic increasing function on Ci by
U: Ci -+ IR, where IR denotes the real space,
such that U (XieC i ) = Ui, i = 1,2, ... , m.
214 Postscript
This transforms to
V j (0 (zkeT)eCj) = Vj, i = 1,2, ... , m,
k = 1,2, ... , I,
I <m.
This means that the ordinal monotonic increasing function V j on the set
C (VC j ) is equivalent to a monotonic increasing transformation on the
set T. This is the well-known theorem on utility functions Vj, that a
monotonic increasing transformation V . 0 of a utility function is itself a
utility function. 50 The result shows that an individual's utility from a
consumption bundle is generated in the first place by his utility based on
ethical parameters that affect his pattern of consumption. In the Islamic
economy an individual's constraint of israf would be a prime ethical
condition deriving utility from consumption to the individual.
Since T is a convex set in IR' and V j e IR m c IR' and V j and V· 0 are
continuous, so the set of V j is also convex. The special point to note in the
above formulation is that an unbounded cone, T, is being mapped on to a
compact set W' = {(Vj): (xj)eC}. This can be possible if a subset of T
gives rise to a set of optimal Vj. In this case furthermore, this subset of Tis
also found to have the fixed points in the set C' = C n 0 (T) c C, and
which were shown to yield the ethico-consumption equilibria. Therefore
a set of equilibrium points in C n 0 (T) yields the corresponding set
of optimal utilities W'.
Exactly the same arguments can be extended for the firm in an Islamic
economy and we can define a set of ethical utility mappings for the firm
by
W" = {( OJ): YjePj }.
The arguments on equilibrium and optimality for OJ corresponding to
points in P are the same as in the case of the ethico-consumption utilities
set W'.
A general equilibrium can now be established in terms of the set of
equilibria in consumption and production and the corresponding
optimal utility functions can be defined. To do this we define the product
set
W= W'x W"
That is W= {(Uj(Xj), Uj(Yj»: (xj)eC; (Yj)eP}.
We also define the continuous mapping
¢: T-+ W,
such that l/> (T) = W.

That is
l/> (z"t T) = W(udxd, U2 (X2), ... , Um (x m ); udyd, ... , u" (y,,)}.
Define u (x) = {UI (xd, U2 (X2), ... , Um (x m )},
u (y) = {UI (YI), U2 (Y2), ... , u" (y,,)}.
By arguments similar to those given earlier, the ethical set Tmaps on to

the set of utilities in W. By the argument of the existence offixed points in
C n n (T) and P n 0 (T) and the corresponding optimality of u (x) and
u(y) we come to the conclusion that for the set of XlltC n neT) and
YlltP c o(T),thefunction W(u(x), u(y»mustbeoptimal. We define W
as the ethical social welfare function, as the envelope of the
individual utilities Uj (Xj), i = 1,2, ... , m; and the firm's utilities
Uj (Yj),j = 1, 2, ... , n.
The construction of the social welfare function can be further extended
to the employment set, the income distribution set, etc. In that case we
have an N -tuple product set W defined as
W = W(UI (xd, U2 (X2), ... , Um (x m ), UI (yd, U2 (Y2), ... , u" (y,,);

Ul (ed, U2 (e2), ... , U~ (e.), ...),
where W", can be defined as the employment utility set
W", = {u;' (el): e"tE}, e, denoting rates of employment
in the set E, k = 1,2, ... , s.
By generality we can drop the repetitions of the internal utility indices
and write
W = W(x, y, e, ... ),
where x= {XI, X2 ... xm}
y = {Yh Y2, ... y,,},
e= {eh e2, .... e.}
We have thus shown that in an Islamic ethico-economic order the
ethical set plays the predominant role in determining the equilibrium set
of consumption, production, etc., bundles. These equilibria then give rise
to optimal welfare indices in each of these sets. The envelope of these
optimal welfare indices is the ethical social welfare function of the Islamic
economy.
216 Postscript
MACROECONOMIC VERSION OF SOCIAL WELFARE

FUNCTION
The macroeconomic version of the microeconomic social welfare

function is now easily determined. Recalling that the sequence
(xd --+ (xo), a minimum average consumption level; that the sequence
(Yj ) --+ (yO), a minimum average target level of production by the firms
measured in efficiency units, etc., the macroeconomic equivalent of the
microeconomic social welfare function is then given by,
W= W(X O, yO, eO, •.. ).
We have now rounded up our arguments on the development of an
ethical social welfare function in an Islamic economy from its micro- to
macroeconomic foundations. 51
The social welfare functions introduced here are also quantifiable and
can therefore be used for specific types of policy analysis in an Islamic
economy. In this social welfare formalisation man is considered as the
centrepiece of the ethico-economic transformation of society.52
This last point conveys the important message that only when these
ethical economic relationships are first formed and progressively re-
inforced at the microeconomic levels the state can thereafter further
promote the ethico-economic foundations of an Islamic society. The
Islamic transformation of a society is therefore a highly democratic
process. It calls on the grassroots development of the individual, and
which progressively develops into a social order. The process of
transformation is not achieved by any type of coercive action of the state
on the individuals, or by institutional changes, whatsoever, even if that is
done in the name of Islam.
Notes and References
INTRODUCTION: TOWARDS A DEFINITION OF ISLAMIC
ECONOMIC THEORY
1. M. A. Zarqa, Social Welfare Function and Consumer Behavior (Jeddah,

Saudi Arabia: International Centre for Research in Islamic Economics,
King Abdulaziz University, 1979) (mimeo.). M. Kahf, 'Contemporary
Challenges to Islamic Economists', AI-Ittihad, vol. 15, no. 2 (Apr 1978).
2. J. A. Wilson, Contemporary Review, vol. 236, no. 1372.
3. Ibn Khaldun, The Muqaddimah: An Introduction to History, trans. F.
Rosenthal (princeton, N. J.: Princeton University Press, 1967).
4. Ibn Taimiyyah, AI-Hisbah Fil Islam (Beirut: Darul Kutb al-Arabiyyah,
1967).1. Ahmad, 'Ibn Taimiyyah on Islamic Economics', Voice of Islam, 9
(11) (Karachi, Pakistan, Aug 1961).
5. Imam Ghazzali, Ihya UJ/um Uddeen, 5 vols (Cairo: Muassassah al-Halabih,
1938).
6. S. A. A. Maududi, 'Economic and Political Teachings of the Quran', in
M. M. Sharif(ed.) A History ofMuslim Philosophy, vol. I (Weisbaden: Otto
Harrassowitz, 1963). Ma'ashiyat-e-Islami (Economics of Islam) (Lahore:
Islamic Publications, 1969). 'Principles and Objectives ofIslam's Economic
System', Criterion, 4 (2) (Karachi, Pakistan, Mar-Apr 1969).
7. Baqir al Sadr, Iqtisaduna (Beirut: Dar ai-Fib, 1968).
8. M. Abduh, Al Islam Deen UI Ilm Wal Madinyah (Islam, the Religion of
Knowledge and Science) (Cairo: AI-Majlis ai-Alia' Li Shun AI-
Islammiyyah, 1964).
9. S. Waliullah, HujitaJ/ah al-Baligah (Beirut: Dar al-Ma'rifat, undated) 2 vols.
10. al Shatibi, AI-Muwafaqat Fi Usul al-Shariah (Cairo: Abdallah Draz al-
Maktabah al-Tijariyah al-Kubra, undated).
11. Muhammad Muhsin Khan (translator), Sahih al-Bukhari (Gujranwala,
Pakistan: Taleem ul-Quran Trust, 1971).
12. W. J. Barber, A History of Economic Thought (Harmondsworth, Middx:
Penguin Books, 1967).
13. G. Debreu, Theory of Value (New York: Wiley & Sons, 1959). K. J. Arrow
and K. Hurwicz, 'On the Stability of the Competitive Equilibrium - 1',
Econometrica, 26 (1958). J. Quirk and R. Saposnik, Introduction to General
Equilibrium Theory and Welfare Economics (New York: McGraw-Hill Inc.,
1968). J. von Neumann, 'A Model of General Economic Equilibrium',
Review of Economic Studies, 13 (1945-6). M. Morishima, Equilibrium,
Stability and Growth (Oxford: Clarendon Press, 1964). H. Uzawa, 'Optimal
Growth in a Two-sector Model of Capital Accumulation', Review of
Economic Studies, 31 (1964).
217
218 Notes and References
14. J. Schumpeter, History of Economic Analysis (New York: Oxford

University Press, 1968).
15. Zarqa, Social Welfare Function and Consumer Behavior . .. , op. cit.
16. S. H. N. Naqvi, 'Ethical Foundations of Islamic Economics', Journal of
Development Studies, vol. 1, no. I (1978).
17. S. H. Nasr, Ideals and Realities of Islam (London: Allen & Unwin, 1975).
18. Schumpeter, History of Economic Analysis, op. cit.
19. E. G. Gilpatrick, Structural Unemployment and Aggregate Demand
(Baltimore, Md: Johns Hopkins University Press, 1966).
20. M. A. Choudhury, 'The Rate of Capitalization in Valuation Models in an
Islamic Economy', Fiscal Policy and Resource Allocation in Islam, eds Z.
Ahmed et al. (International Centre for Research in Islamic Economics,
Jeddah, and Institute of Policy Studies, Islamabad, Pakistan, 1983).
21. K. J. Arrow, Social Choice and Individual Values (New Haven, Conn., and
London (U.K.), 1976).
I PRINCIPLES OF ISLAMIC ECONOMICS
1. J. Schumpeter, History of Economic Analysis (New York: Oxford

2. Quran, Surah L, verse I.
3. Quran, Surah LV, verse 9.
4. Quran, Surah II, verses 30-31.
5. A. H. A. A. Sulayman, 'The Theory of Economics of Islam', Proceedings of
the Third East Coast Regional Conference (Muslim Students Association of
the United States and Canada, April, 1968).
6. Ibn-al Qayyim, Tahdhib Sunan Abu Dawad, vol. 5 (Cairo: Undated).
7. Ibn-al Qayyim, Tahdhib Sunan Abu Dawad, op. cit.
8. Quran, Surah 59, verse 41.
9. S. W. A. Hussaini, Principles of Environmental Engineering Systems
Planning in Islamic Culture: Law, Politics, Economics, Education, and
Sociology ofScience and Culture (Stanford University, Report EEP-4I. Dec.
1971).
10. Quran, Surah 4, verse 17.
11. M. A. Choudhury, 'A Social Service Model in the I. Economy', Proceedings
of the Seventh Annual Conference (Association of Muslim Social Scientists,
Marion College, Indianapolis, Ind. July, 1978).
12. M. Muslehuddin, Insurance and Islamic Law (Lahore: Islamic Publications
Ltd, 1969).
13. M. Bailey, National Income and the Price Level (New York: McGraw Hill,
1971).
14. M. A. Choudhury, 'A Mathematical Formulation of the Principle of
Mudarabah: The Profit-sharing in Islam', Proceedings of the Third National
Seminar (Gary, Ind.: Association of Muslim Social Scientists, May 1974).
Islamic Economy', Fiscal Policy and Resource Allocation in Islam, ed. Z.
Ahmed et al. (International Centre for Research in Islamic Econornics,

Jeddah, Saudi Arabia and Institute of Policy Studies, Islarnabad, Pakistan,
1983).
16. M. A. Choudhury, An Islamic Social Welfare Function, (Indianapolis, Ind.:
American Trust Publications, 1983).
17. The Islarnic Foundation for Science and Technology for Developrnent
(IFSTAD) is now a rnernber body of the United Nations Programme on
Science, Technology and Developrnent (see Reports ofIFSTAD presented
at the 10th and lith Islarnic Conferences of Foreign Ministers,
Organisation of Islarnic Conferences, Jeddah, Saudi Arabia).
18. S. N. H. Naqvi, 'Ethical Foundations of Islamic Econornics', Journal of
Development Studies, Institute of Developrnent Studies, NWFP
Agricultural University, Peshawar, Pakistan, vol. I, no. 1 (1978).
19. A. K. N. Reddy, 'Methodology for Selection of Environmentally Sound and
Appropriate Technologies' (Unpublished), United Nations Environment
Prograrn.
2 AN ISLAMIC APPROACH TO THE THEORY OF CONSUMER

DEMAND
1. J. Marchak, 'Rational Behaviour, Uncertain Prospects, and Measurable

Utility', Econometrica, vol. xviii (1950).
2. Jererny Bentharn said, 'as to the proposition that passion does not calculate,
this, like rnost of these very general and oracular propositions is not
true .... I would not say that even a rnadrnan does not calculate. Passion
calculates, rnore or less, in every rnan.' (An Introduction to the Principles of
Morals and Legislation (New York: Hafner, 1963».
3. J. Schurnpeter, History of Economic Analysis (New York: Oxford
4. W. Edwards, 'The Theory of Decision Making', Psychological Bulletin (July
1954). Also refer to E. K. Hunt and J. G. Schwartz, 'Introduction' to A
Critique of Economic Theory (Harrnondsworth, Middx: Penguin Books,
1972).
5. G. S. Becker, 'Irrational Behavior and Econornic Theory', in The Economic
Approach to Human Behavior, ed. G. S. Becker (Chicago and London:
University of Chicago Press, 1976).
6. J. M. Henderson, and R. E. Quandt, Microeconomic Theory (New York:
McGraw-Hill Inc., 1980, chap. 3).
7. K. J. Arrow, 'Gifts and Exchanges', in Altruism, Morality and Economic
Theory, ed. E. Phelps (New York: Russell Sage Foundation, 1976).
8. Such a case happened, for exarnple, during the tirne of Caliph Abu Bakr,
who waged war on those who refused to pay zakah to the city-state of
Medina.
9. O. Llewellyn, 'Islarnic Jurisprudence and Environrnental Planning', Journal
of Research in Islamic Economics, vol. I, no. 2 (Winter 1984).
10. K. J. Lancaster, 'A New Approach to Consumer Theory', Journolof

Political Economy (1966).
11. F. P. Ramsey, 'A Mathematical Theory of Saving', The Economic Journal,
38 (1928).
12. J. M. Henderson, and R. E. Quandt, Microeconomic Theory, op. cit. chap. 3.
3 FIRST-ORDER EFFICIENCY CONDITIONS OF THE FIRM IN AN

ISLAMIC ECONOMY
1. M. Ariff, 'Islamic Ethics and Economics', Proceedings ofthe Seventh Annual

Convention (Indianapolis, Ind.: June 1979). Association of Muslim Social
Scientists of the United States.
2. M. A. Zarqa, 'Economics of Project Evaluation in Islamic Perspective',
Proceedings of the Internotionol Seminor on Monetary and Fiscal Economics
of Islam (Islamabad, Jan 1983).
3. S. M. Ahmad, Economics of Islam (Lahore: Sh. Muhammad Ashraf Press,
1968).
4. P. A. Samuelson, Foundiltions ofEconomic Anolysis (New York: Atheneum,
1970).
5. The other objective functions for the firm are profit, output and revenue
maximisation, which all yield the same efficiency conditions in resource
allocation.
6. J. M. Hendersen, and R. E. Quandt, Micro-economic Theory 2nd ed.
(New York: McGraw-Hill Inc., 1971).
5 THE ROLE OF ZAKAH, THE ISLAMIC QUASI WEALTH TAX, IN

RESOURCE ALLOCATION
1. Quran, chapter 9, verse 60.

2. M. Kahf, 'Economics of Muslim Minorities in a Non-Islamic
Environment', Islamic Economics, Proceedings of the First Symposium on
the EConomics of Islam in North America (Indianapolis, Ind.: The
Association of Muslim Social Scientists, Mar. 1977).
3. K. J. Arrow, 'The Organization of Economic Activity: Issues Pertinent to
the Choice of Market Versus Non-Market Allocation,' in Public
Expenditure and Policy Anolysis, ed. R. H. Haveman and J. Margolis
(Chicago: Markham Publishing Co., 1970).
4. Ibn. Khaldun, Muqaddima, trans. Franz Rosenthal Princeton: Ballinger
Series xliii (princeton University Press, 1958).
5. N. J. Barber, A History of Economic Thought (New York: Penguin Books,
1977).
6. K. Ahmed, Principles of Islamic Economics (Lahore, Pakistan: Islamic

Publications Ltd, 1968).
7. B. A. Weisbrod, 'Collective Action and the Distribution of Income: A
Conceptual Approach', in Public Expenditure and Policy Analysis, ed. R. H.
Haveman and J. Margolis (Chicago: Markham Publishing Co., 1970).
8. H. Leibenstein, 'Allocative Efficiency Vs. X-Efficiency', American Economic
Review (1966).
9. M. A. Mannan, Islamic Economics (Lahore, Pakistan: Sh. Muhammad
Ashraf, 1975).
10. M. A. Choudhury, 'A Social Service Model in the I-Economy, Proceedings
of the Seventh Annual Conference, (Indianpolis, Ind. Association of Muslim
Social Scientists: June 1978).
II. J. A. Robinson, 'The Concept of Equity in the Carter Report', in
Canada's Tax Structure and Economic Goals (Toronto: York University,
1967).
12. For example, the Heritage Fund of the Government of Saskatchewan,
Canada, which is set up to meet the needs of exigency funding of resource
related development programmes.
13. J. Mincer, 'Labor Force Participation and Unemployment: A Review of
Recent Evidence', Readings in Labor Market Analysis, ed. J. F. Burton et al.
(Holt, Rinehart & Winston, 1971).
14. G. J. Stigler, 'The Economics of Minimum Wage Legislation', American
Economic Review, vol. 36 (June I 946).
15. Government of Canada, Information Canada. Income Support and
Supplementation' (Ottawa, 1975).
16. Similar ideas are developed by B. A. Weisbrod in, External Benefits ofPublic
Education (princeton University Industrial Relations Section, Princeton, N.
J., 1964).
17. P. K. Hoover and L. H. Longley-Cook. Life and Other Contingency, Vol. I
(Cambridge University Press, 1957).
6 AN ANALYTICAL MODEL OF PROFIT-SHARING IN AN ISLAMIC

ECONOMY

Islamic Economy', Fiscal Policy and Resource Allocation in Islam, ed. Z.
Jeddah, Saudi Arabia and Institute of Policy Studies, Islamabad, Pakistan,
1983).
2. K. J. Arrow and R. C. Lind, 'Uncertainty and the Evaluation of Public
Investment Decisions', American Economic Review, 60 (1970).
3. Let 1ti denote the profits of the individual partners in a joint venture, i = 1,2.
1t = 1tl -1t2, denote the total profit from the joint venture. The profit rate on
1t is defined by p.
R-C
P=-C'
Note that p is not the time rate of change of profits. The shares of this profit
rate to the i lh partner is,
(Cdc)-p, i = 1,2,
with C denoting the total cost of investment, made up of outlays of the
partners, Ci , i = 1,2 and R denoting the total returns from the joint venture.
The profit-sharing rate is now defined by (Cdc)·p, i = 1, 2 and comprises
the profit rate, p, in the joint project and the profit-sharing ratios (CdC),
i = 1, 2.
4. M. A. Choudhury, 'The Rate of Capitalization ... " op. cit.
5. M. Ariff, 'Islamic Ethics and Economies', Proceedings of the Seventh Annual
Conference (Indianapolis, Ind.: Association of Muslim Social Scientists,
Marion College, June 1978).
6. P. A. Samuelson, Foundations of Economic Analysis (New York: Atheneum,
1970).
7. W. Sharpe, Portfolio Theory and Capital Markets (New York: McGraw-Hill
Inc., 1970).
8. G. Debreu, Theory of Value (New York: Wiley & Sons, 1959).
9. M. D. Intrilligator, Mathematical Optimization and Economic Theory
(Englewood Cliffs, N.J: Prentice-Hall, 1971).
10. J. M. Henderson and R. E. Quandt, Microeconomic Theory (New York:
McGraw-Hill Inc., 1971).
II. M. A. Zarqa, 'An Islamic Perspective on the Economics of Discounting in
Project Evaluation', Fiscal Policy and Resource Allocation in Islam, eds. Z.
Jeddah, Saudi Arabia and Institute of Policy Analysis, Islamabad, Pakistan,
1983).
12. E. S. Phelps, 'Population Increase', Canadian Journal of Economics (Aug.
1968).
Ltd, 1969).
7 MICROECONOMIC DECISON-MAKING IN AN
ISLAMIC FRAMEWORK
I. J. M. English, 'New Approaches to Economic Comparison for Engineering

Projects', Journal of Industrial Engineering (Nov-Dec 1961).
2. A. R. Prest, and R. Turvey, 'Cost-benefit Analysis: A Survey', Economic
Journal, vol. 75 (1965).
3. D. Bodenhorn, 'On the Problem of Capital Budgeting', Journal of Finance,
vol. xiv (Dec 1959).
4. L. E. Bussey, The Economic Analysis of Industrial Projects (Englewood
Cliffs, N. J. Prentice-Hall, 1978).
5. D. Vickers, The Theory of the Firm: Production, Capital and Finance (New
York: McGraw-Hill 1968).
6. W. H. Jean, The Analytical Theory of Finance (New York: Holt, Rinehart &
Winston, 1970).
7. K. J. Arrow, and M. Kurz, Public Investment, the Rate of Return, and
Optimal Fiscal Policy (Baltimore, Md: Johns Hopkins University Press.
1970).
8. W. Sharpe, Portfolio Theory and Capital Markets (New York: McGraw-Hill
Inc., 1970).
9. Vickers, The Theory of the Firm, op. cit.
10. Arrow, and Kurz, Public Investment, op. cit.
11. G. A. Taylor, Managerial and Engineering Economy (New York: Van
Nostrand Co., 1975) chap. 1.
12. J. G. Mclean, 'How to Evaluate New Capital Investments', Harvard Business
Review, vol. 36, no. 6 (Nov-Dec 1958).
13. V. L. Smith, Investment and Production (Cambridge, Mass.: Harvard
University Press, 1966) chap. v.
14. E. Schwartz, Theory of the Capital Structure of the Firm', Journal of
Finance, vol. xiv, no. 1 (Mar 1959).
15. F. S. Hillier, The Derivation of Probabilistic Information for the Evaluation
of Risky Investments', Management Science, vol. 9, no. 3 (Apr 1963).
16. R. A. Musgrave, 'Cost-benefit Analysis and the Theory of Public Finance',
Journal of Economic Literature, vol. 7, no. 3 (1969).
17. Vickers, The Theory of the Firm, op. cit.
18. J. Marschak, 'Rational Behaviour, Uncertain Prospects and Measurable
Utility', Econometrica, vol. 18, (Apr 1950).
19. The postulate of risk-aversion by the firm having a utility function U, in
expected profits n:, and risk (12 is expressed by
U = Urn:, (12)
conditional to
aU/an: > 0, OU/0(12 < 0, bU/f>t <0.
20. K. J. Arrow, Social Choice and Individual Values (New York: Wiley & Sons,
1951).
21. O. Lange, 'The Foundation of Welfare Economics', Econometrica, vol. 10,
(1942).
W. J. Baumol, Welfare Economics and the Theory of the State (London: Bell,
1965).
22. The incorporation of taste along with expected returns and risk over time in
the firm's utility function would mean that the firm's income is increasing
and it is in a position to produce special types of products to meet the
consumer demand for those products.
23. H. B. Chenery, The Interdependence ofInvestment Decisions', in Readings
in Welfare Economics, ed. K. J. Arrow and T. Scitovsky (Homewood, Ill.:
Irwin 1969).
24. Chenery, ibid.
25. J. Hirshleifer, Investment, Interest and Capital (Englewoods Cliffs, N. 1.
Prentice-Hall, 1970). chap 9 and 10.
McGraw-Hill Inc., 1971) chap. 7.
27. P. A. Samuelson, Foundations ofEconomic Analysis (New York: Atheneum,

1970) chap. VII.
28. M. A. Choudhury, 'Towards a Definition of Islamic Economic Theory and
Development', Contemporary Review, vol. 239, no. 1387 (Aug 1981).
30. This note is all-prevading in the Quranic revelation, Surah LV.
32. Quran, Surah II, verses 30-1.
33. Quran, Surah XVII, verse 27.
34. Quran, Surah IX, verse 71.
35. Quran Surah XLI, verse 10.
36. O. Llewellyn, 'The Objective ofIslamic Law and Admininistrative Planning
for Agricultural Use' (mimeo), Department of Landscape Architecture and
Regional Planning, University of Pennsylvania.
37. M. A. Mannan, Islamic Economics (Lahore, Sh. Muhammad Ashraf, 1975).
Ishimic Economy', Fiscal Policy and Resource Allocation in Islam, ed. Z.
Ahmed et al. (Jeddah: International Centre for Research in Islamic
Economics, King Abdulaziz University, and Institute of Policy Studies,
Islamabad, Pakistan, 1983).
39. W. W. Rostow, The Stages of Economic Growth (New York: Cambridge
40. The consumption referred here is not of consumer durables like social
security, education, etc., but of luxury goods and excessive amount of
perishable goods and services.
41. An interesting pioneering study on the economics of altruism is to be found
in David Collard's, Altruism and Economy: A Study in Non-Selfish Economics
(New York and Oxford: Oxford University Press, 1978).
42. Even in a Western economy the non-profit sector called the 'third sector' is
found to contribute significantly to aggregate economic activity. See Burton
A. Weisbrod's, The Voluntary Non-Profit Sector: An Economic Analysis
(Lexington, Mass., and Toronto: Heath, Lexington Books, 1977).
43. C. von Weizacher,'Existence of Optimal Programs of Accumulation for an
Infinite Time Horizon', Review of Economic Studies, vol. 32, (Apr 1965).
44. R. A. Abrams, and U. S. Karmarkar, 'Infinite Horizon Investment-
Consumption Policies', Management Science, vol. 25, no. 10, (Oct 1979).
45. The usual types of stochastic processes covered are Markov processes. See
K. Borch, 'Decision Rules depending on the Probability of Ruin', Oxford
Economic Papers (Mar 1968); F. Hanssman, 'Probability of Survival as an
Investment Criterion', Management Science (Sep 1968); J. Steindl, Random
Processes and the Growth of Firms (New York: Hafner Publishing Co., 1965)
chaps iv and v.
46. The problem poised is that in the presence of uncertainty over infinite time
investment planning, the integral of the discounted utility of returns and risk
may not converge and therefore an optimal solution for the decision
problem will not exist.
47. R. Dorfman, P. A. Samuelson, and R. M. Solow, 'Efficient Programs of
Capital Accumulation', in Linear Programming and Economic Analysis (New
York: McGraw-Hili Inc., 1958).
E. Malinvaud, 'The Analogy between Atemporal and Intertemporal
Theories of Resource Allocation', Review of Economic Studies, vo!' xxviii

(June 1961).
48. A similar problem, but for a consumer and over intertemporal time horizon
is solved by J. M. Henderson, and R. E. Quandt, in their Microeconomic
Theory (New York: McGraw-Hili Inc., 1971) chap. 8.
49. The interpretation here would be of the time variable that can be associated
with the probability limit of {Ps } between the nearest two values of time for
given values of p •.
50. J. L. Riggs, Engineering Economics (McGraw-Hili, 1977) chap. i.
51. M. A. Choudhury, An Islamic Social Welfare Function (Indianapolis, Ind.:
American Trust Publication, Jan 1983) Chapter III.
52. L. E. Bussey, The Economic Analysis of Industrial Projects (Englewoods
Cliffs, N. J. Prentice-Hall, 1978) chap. 3.
53. F. M. Bator, 'The Simple Analytics of Welfare Maximization', American
Economic Review, vo!' 47, (Mar 1957).
54. The constancy of substitution possibility at all income levels as a condition
for homotheticity of isoquant maps is shown by L. R. Christensen, and D. W.
Caves, in 'Global Properties of Flexible Functional Forms', American
Economic Review, (June 1980).
55. M. D. Intrilligator, Mathematical Optimization and Economic Theory
(Englewoods Cliffs, N. J.: Prentice-Hall, 1971) chap. 10.
56. Note that due to the predominance of investment activity and of consumer
durables, the idea of human capital can be treated in an Islamic framework
more from an investment approach. See H. G. Johnson, 'Towards a
Generalized Capital Accumulation Approach to Economic Development',
Residual Factor and Economic Growth, (Paris: OECD 1964).
57. The anonymous reviewer of this article has correctly pointed out that the
optimization problem and its zakah-investment-benefit constraints given in
expression (12) would hold true in the short run, but not necessarily so in the
long run. He has correctly pointed out that this would be so, because the
amounts of profits being subject to zakah could increase in the long run.
Thus, money allocated for zakah would be higher.
Accordingly, the shortrun optimisation problem presented in expression
(12) is now reformulated for the long-run by the following analogue:
max (log B b, Zb,), }
subject to B = AI za, [a 2, (12')
Z = A 2 Ia,.
Note that now b l ~ 0,b 2 ~ O,al ~ 0,a2 ~ 0,a3 ~ O,A I > 0,A 2 > 0.
< < <
Thus no condition are now placed on the specific zakah-investment-benefit
relations. When, for example, the coefficients are all positive, zakah,
investment and benefits are positively related, and so on.
The Lagrangian connected with the optimization problem (12') is L',
L' = max (log Bb'zb'_pl(B-AIza'I a,) -P2(Z-A 2 Ia,).
The first-order conditions of maximising L' are found to be
bl
B =- (l3')
PI'
PI (a l BIZ) - P2 = b 21Z, (14')

PI (a2B)+ P2 (a3Z) = O. (15')
Oearly now, the coefficients bl, bl, aI, al, a3, being constants, the mathe-
matical and thereby the economic results connected with the expressions
(13'}-(15') are exactly analogous to those related to the optimisation
problem (12). The optimisation problem given by (12') is therefore the long-
run analogue of the problem presented by expression (12), and which holds
true in the short run.
58. M. D. Intrilligator, Mathematical Optimisation and Economic Theory, op.
cit., chap. 3.
59. M. A. Choudhury, doctoral thesis at the University of Toronto titled Some
Aspects of Optimal Human Capital Theory and Economic Growth: A
Theoretical and Empirical Analysis (part published), Oct 1976, chap. 1
60. The detailed rationale for this form of the investment utility function in an
Islamic economy is developed by the author in his paper titled, 'The rate of
capitalization in valuation models in an Islamic economy, (mimeo.)
International Centre for Research in Islamic Economics, King Abdulaziz
University, April, 1980.
61. M. D. Intrilligator, Mathematical Optimisation and Economic Theory, op. cit.
chap. 14.
The dots over the variables denote time derivatives of the variables.
62. P. A. Neher, Economic Growth and Development (Wiley & Sons, 1971) chap.
2.
8 FORMATION OF SOCIAL ORDERING IN AN ISLAMIC WELFARE

ECONOMY
1. K. J. Arrow, Social Choice and Individual Values (New Haven, Conn., &
London: Yale University Press, 1976).
2. O. Lange, 'The Foundations of Welfare Economics', Econometrica, 10
(1942).
3. A. Radomysler, 'Welfare Economics and Economic Policy, Econometrica, 13
(1946).
4. P. A. Samuelson, Foundations of Economic Analysis (New York: Atheneum,
1965).
5. G. Debreu, Theory of Value, Cowles Foundation (New York: Wiley & Sons,
1965).
McGraw-Hili, 1971).
7. O. Lange, 'The Foundations of Welfare Economics', op. cit.
8. Samuelson, Foundations of Economic Analysis, op. cit.
9. S. H. Nasr, Ideals and Realities of Islam, 2nd ed. (London: Allen & Unwin,
1975).
10. M. A. Choudhury, 'Foundations oflslamic Economics', M. A. major paper

(Department of Political Economy, University of Toronto, 1973).
11. Nasr, Ideals and Realities of Islam, op. cit.
12. Arrow, Social Change and Individual Values, op. cit.
Ltd, 1969).
14. M. A. Zarqa, 'Social Welfare Function and Consumer Behavior: An Islamic
Formulation of Selected Issues' (mimeo) (Jeddah: International Centre for
Research in Islamic Economics, King Abdulaziz University, 1979).
15. M. A. Choudhury 'The Rate of Capitalization in Valuation Models in an
Islamic Economy', Fiscal Policy and Resource Allocation in Islam, eds Z.
16. J. A. Schumpeter, History of Economic Analysis (New York: Oxford
17. Ibn Taimiyya, AI-Hisbah, op. cit.
18. A. Azim, 'Economic Views of Ibn Taimiyyah', doctoral dissertation (un-
published) (Aligarh University, India, 1981).
19. Ibn Taimiyyah, AI-Hisbah, op. cit.
20. O. Llewellyn, 'The Objective of Islamic Law and Administrative Planning
for Agricultural Use', (mimeo.) (Department of Landscape Architecture and
Regional Planning, University of Pennsylvania, 1980).
21. Llewellyn, 'The Objective of Islamic Law ... " op. cit.
22. J. C. Harsanyi, 'Cardinal Welfare, Individualistic Ethics, and Interpersonal
Comparisons of Utility', Journal of Political Economy, 63 (1955).
23. Harsanyi, 'Cardinal Welfare ... " op. cit.
9 INVESTMENT THEORY IN AN ISLAMIC PERSPECTIVE
1. F. H. Knight, 'The Quantity of Capital and the Rate of Interest, Part II',
Journal of Political Economy, (Oct 1936).
2. O. Lange, 'The Place of Interest in the Theory of Production', Review of
Economic Studies, vol. 3, (1936).
3. J. Robinson, 'The Production Function and the Theory of Capital', Review
of Economic Studies, vol. 21 (1953-4).
4. P. Sraffa, 'Reduction to Dated Quantities of Labour', in Production of
Commodities by Means of Commodities: Prelude to a Critique of Economic
Theory (Cambridge: Cambridge University Press, 1960).
5. R. Dorfman, P. Samuelson, and R. M. Solow, 'Efficient Programs of Capital
Accumulation', in Linear Programming and Economic Analysis McGraw-
Hill Inc., 1958).
6. D. Meiselman, The Term Structure ofInterest Rates (Englewood Cliffs, N. J.,
Prentice-Hall, 1962).
7. J. Robinson, 'Capital Theory up to Date', Canadian Journal of Economics,
vol. 3, 1970.
8. Eugene von, Bohm-Bawerk, Capital and Interest, vol. i. (London: William

Smart, 1890; South Holland, IIl.: Libertarian Press, 1959).
9. Sraffa, 'Reduction to Dated Quantities of Labour', op. cit.
to. P. Garegnani, 'Heterogeneous Capital, the Production Function and the
Theory of Distribution', Review of Economic Studies, vol. 37, (1970).
11. Dorfman, et al., 'Efficient Programs of Capital Accumulation', op. cit.
12. Robinson, 'Capital Theory Up to Date', op. cit.
13. O. Lange, 'Professor Knight's Note on Interest Theory', Review of Economic
Studies, vol. 4, (1937).
14. R. B. Ekelund, Jr. and R. F. Herbert, A History of Economic Theory and
Method (New York: McGraw-Hill Inc., 1975).
15. Bohm-Bawerk, Capital and Interest, op. cit.
16. Dorfman et al., 'Efficient Programs of Capital Accumulation', et al. op. cit.
17. O. Lange, 'The Theory of Interest and the Theory of Production', op. cit.
18. Bohm-Bawerk, Capital and Interest, op. cit.
19. J. F. Weston, 'The Profit Concept and Theory. A Restatement', Journal of
Political Economy, vol. 62 (Apr 1954).
20. M. Uzair, 'Some Conceptual and Practical Aspects of Interest-Free
Banking', Studies in Islamic Economics, ed. Khurshid Ahmad, Jeddah (Saudi
Arabia: International Centre for Research in Islamic Economics, King
Abdulaziz University, and The Islamic Foundation, United Kingdom,
1980).
21. M. J. Bailey, National Income and the Price Level: A Study in Macro-
Economic Theory (New York: McGraw-Hill Inc. 1971).
22. R. Eisner and R. H. Strotz, 'Research Study Two: Determinants of
Business Investment', in Commission on Money and Credit, Impacts of
Monetary Policy (Englewood Cliffs, N.J., Prentice-Hall, 1963).
23. J. R. Meyer, and E. Kuh, 'Accelerator and Related Theories of Investment:
An Empirical Inquiry', Review of Economics and Statistics, vol. 37, no. 3 (Aug
1955).
24. M. Muslehuddin, Insurance and Islamic Law (Lahore: Islamic Publications,
1969).
25. Muslehuddin, ibid.
26. Imam Muslim, Kitab al-Shahi (Cairo (undated).
27. These are a set of recorded traditions relating to the Muslim relations with
the Jews of Khaybar, a place in the peninsula of Arabia during the time of
Prophet Muhammad.
28. Ibn Abidin, Radd al-Mukhtar, Bab al-Riba, vol. 4 (Cairo).
29. Y. A. Ali, The Holy Quran: Text, Translation and Commentary, see foot-note
to Surah II, verse 275.
30. S. Ahmad, 'Reflections on the Concept and Law of Riba', Outlines of Islamic
Economics (Indianapolis, Ind. Association of Muslim Social Scientists. Mar
1977).
31. M. A. Mannan, Islamic Economics: Theory and Practice (Lahore: Sh.
Muhammad Ashraf Press, 1975).
32. S. N. H. Naqvi, 'Interest Rate and Intertemporal Allocative Efficiency in an
Islamic Economy', paper presented at the seminar on The Monetary and
Fiscal Economics of Islam, Mecca, October 1978.
33. Let g denote the rate of growth of dividends per share, k, denote the fraction
of total profits retained in each period of time, i.e. D (t) = X (t) (1 - k,)
k. = k - k, denotes the amount of external capital raised per period of
time
P denotes the internal rate of return.
Then, the present value of future dividends will be
D(O) L «I+g)t/(I+p)t+1
t=0
= D (O)/(p - g) = X (0) (1 - k,)/(p - g).
By virtue of the dividend approach of valuation of returns, the above must
equal V (0), the present value of the firm. It can be shown that
V(O) = X (0) (1- k)/(p - kp*).
Hence X (0) (1- k,)/(p - g) = X (0) (1 - k, - k.)/p - kp*.
Therefore it follows that
9 = kp* «(1 - k,)/(1 - k)) - k.p (1/(1- k)).
Ifall financing is internal, then 9 = kp*,or,p* = g/k,showing that, if profit is
shared among the shareholders without previously fixing p*, then the rate of
return becomes equal to the growth rate of dividends.
34. R. G. D. Allen, Macroeconomic Theory (London: Macmillan, 1967).
35. I. Fisher, The Theory of Interest (New York: Macmillan, 1930). The Rate of
Interest (New York: Macmillan, 1907).
J. Hirshleier, 'On the Theory of Optimal Investment Decision', Journal of
Political Economy, vol. 66, no. 4 (Aug 1958).
36. M. A. Choudhury, 'Interest Rate and Intertemporal Allocative Efficiency. In
an Islamic Economy: Issue Revisited' Discussion paper no. 6 (International
Centre for Research in Islamic Economics, King Abdulaziz University,
Jeddah, 1982).
37. Quran, Surah, XVII, verse 27.
38. Quran, Surah V, verse 90.
39. Quran: an extension of the meaning of Surah XII, verses 9-12.
40. M. A. Mannan, Islamic Economics: ... , op. cit.
41. The point that it is the profit-sharing rate and not the profit rate that should
be used as a discount rate is formalised as follows: Let p denote the total
profit from a joint venture, with Pi> i = 1, 2, being the profits of individual
partners, so that p = PI + P2' Also let PI = sp, P2 = (1 - s)p, where s denotes
a constant share of p. By definition the profit rate on p is equal to e (p) say,
with, e (p) = (R - C)/C, where R denotes total returns and C denotes total
costs, C = C I + C 2 , C;, i = 1,2, being the costs of individual partners.
Now (CdC) e (pd = se (p), (C 2 /C) e (P2) = (l-s) e (p), and
(CdC) e (PI) + (C 2/C)e (P2) = e (p).
The two terms on the left hand side of this expression denote the individual
profit sharing rates, i.e. the usual profit rates weighted by the respective
percentage shares of costs.
42. Quran, Surah II, verse 275.
43. M. A. Choudhury, 'A Mathematical Formulation of the Principle of

Mudarabah, the Profit-sharing in Islam', Proceedings of the Third National
Seminar, (Gary, Ind.: Association of Muslim Social Scientists, May 1974).
Islamic Economy', Fiscal Policy and Resource Allocation in Islam', eds Z.
Jeddah, Saudi Arabia, and Institute of Policy Studies, Islamabad, Pakistan,
1983.
45. S. S. Alexander, 'Mr. Keynes and Mr. Marx', Review of Economic Studies
(Feb 1940).
10 MACRO CONSUMPTION FUNCTION IN AN ISLAMIC

FRAMEWORK
1. K. Ahmed, 'Economic Development in an Islamic Framework', in Studies in

Islamic Economies, ed. K. Ahmed, (Leicester: Islamic Foundation, 1980).
2. 'Spending' is used to include not only what is called 'consumption' in
economics, but also the investment expenditures, transfers, lending and
savings in the form of hoarding or otherwise.
3. It is agreed among companions of the Prophet, the generation succeeding
the companions and Fuqaha, that one should spend from what is left after
meeting ones needs and not that one should spend all that is spare.
4. M. Kahf, "A Contribution to the Theory of Consumer Behaviour in an
Islamic Society", in Studies in Islamic Economics, ed. K. Ahmed (Leicester:
Islamic Foundation, 1980).
5. It was argued by a commentator that the assumption -
au = constant would
iJE 2
not allow the indifference curve to be convex and should rather make it
concave leading to a corner solution which is not a desirable Islamic
solution, without going into the implication of constant marginal utility of
E2 on convexity. I express my gratitude to Dr Mohammad Anas Zarqa for
pointing out that the assumption of constant marginal utility of E2 is not
necessarily required. Instead it can be safe to assume a declining marginal
utility of E 2. His argument, in brief, is as follows: E2 has a utility just as E1
has. Even a secular consumer likes to spend E2 to feel some satisfaction that
he is not selfish and is nice to others. For a secular consumer this utility of E 2 ,
however, will be too small, leading to a too small level of E 2 • For an Islamic
Consumer E2 will be larger because he feels more satisfaction in E2 due to his
different objectives of life and beliefin the reward of hereafter, E2 will have a
declining marginal utility as E1 has. This is because a Muslim has been asked
to be moderate in his spending even on E2 as has already been discussed
above. It can be safely argued that E2 in nature is the same as E 1, thus having
diminishing marginal utility. The analysis in this chapter, however, con-
tinues on the assumption of constant marginal utility of E 2 . The assumption
of declining marginal utility of E2 is supposed to have no effect on the

conclusions.
6. The constraints requiring the Muslims to be moderate may imply a higher
level of C. if the secular behaviour in the society is that of a niggard. This is,
however, very unlikely, particularly keeping in view the consumption
pattern of existing societies in Muslim countries.
7. Note that Zt is spending in the way of Allah beyond zakah. This is the
proportion of annual income that is spent by a God-fearing person in the
way of Allah in addition to spending 2! per cent zakah from his wealth.
11 MACROECONOMIC RELATIONS IN THE ISLAMIC ECONOMIC

ORDER
1. J. Schumpeter, History of Economic Analysis (New York: Oxford University

Press, 1968).
2. J. Stigler, 'The Influence of Events and Policies on Economic Theory',
American Economic Review (May 1960).
Also refer to John C. O'Brien's paper, 'The Economist's Quandary: Ethical
Values', International Journal of Social Economics, vol. 8, no. 3 (1981).
3. O. Lange, Introduction to Econometrics (Oxford: Pergamon Press, 1966)
chap. iii.
4. P. Streeten, 'Approaches to a New International Economic Order', World
Development, vol. 10, no. 1 (1982).
5. - - , Development Perspectives (New York: St Martin's Press, 1981)
pp.334-65.
6. - - , 'Basic Needs in the year 2000', Pakistan Development Review, vol. xix,
no. 2 (Summer 1980).
7. M. A. Choudhury, 'Principles of Islamic Economics', Middle Eastern
Studies, vol. 19, no. 1 (Jan 1983).
8. This is known as rububiyyah in Islamic literature. See 'The Theory of the
Economics of Islam: The Economics of Tawhid and Brotherhood',
Proceedings, Third East Coast Regional Conference, Muslim Students'
Association, Pawling (New York, 12-14 Apr, 1968).
9. Zarqa, M. A. 'An Islamic Perspective on the Economics of Discounting in
Project Evaluation', in Fiscal Policy and Resource Allocation in Islam, eds Z.
Ahmed, et al. (International Centre for Research in Islamic Economics,
10. M. A. Choudhury, 'An Analytical Model of Profit Rate-Ratio Adjustment
Under the Profit Sharing System in Islam and its Implications on Risk
Diversification', Hacettepe University Bulletin of Administrative Sciences,
vol. 1, no. 4. (Ankara, Turkey, Jan 1981).
11. M. A. Choudhury, 'The Doctrine of Riba', Journal of Development Studies,
vol. ii, no. 1 (1979) (University of Peshawar).
12. M. Metawalli, Macro-economic Models of Islamic Doctrine (Department of
Economics, University of Queensland, Australia).
Metawalli's formulation briefly stated is the following:
Expected rate of profit

P2 I---------------------------~
P, ~--------------~
Volume of
o 1 - - 7 ' - - - - - - - ' - - - - - - - - ' - - investment
12
P= -til -z
The expected rate of profit P, after deducting the rate of zakah, Z, on profits,
is given by
P = P (I-Z).
If t is the rate of zakah on savings, then the effective expected rate of return
on investment will be given by P E
P E =P(I-Z)+t.
Investment will cease when P E = 0, i.e. when
t
P=---
l-Z
But from this stage on, investments will be undertaken for
t
P> - - - -
l-Z
Thus, when P = 0, investment I is equal to 10 •
13. R. H. Haveman, 'Toward Efficiency and Equity Through Direct Job
Creation', in Social Policy (May/June 1980).
14. The accumulated change in income at time t + n + 1, denoted by ':\Y, is the
sum of changes in income from the period t + 1 to t + n, i.e.
.:\Y = .:\Yt + 1 + ':\Yt + 2 + ':\Yt + 3 ... + .:\Yt +,·
Let the contribution of desired investment I, to national income in period
j, be given by
Yj = aj-(t+l) I,
therefore ':\Yj = a j - (t + I) ,:\1,
where a is a constant.
The cumulative equation of changes in national income can now be
written as
I-a'
.:\Y = - - x M .
I-a
It is known that changes in investment are activated by changes in the zakah

amount from savings and wealth held in idle state. Therefore this
relationship of zakah to investment can be written as
M =bI1Z.
The multiplier of zakah on income is then given by
I-a"
I1Y = - - x b x I1Z.
I-a
15. Siddiqui, N. 'Economics of Profit Sharing', in Fiscal Policy and Resource
Allocation in Islam, eds Z. Ahmed et al. (International Centre for Research in
Islamic Economics, Jeddah, and Institute of Policy Studies, Islamabad,
Pakistan, 1983).
16. M. Metawalli, Macro-economic Models of Islamic Doctrines, op. cit.
17. Y. P. Venieris, and F. D. Sebold, Macro-Economics Models and Policy New
York: Wiley & Sons, 1977) pg. 167-9.
18. The case can be likened to the demand-pull price changes in the classical.
Quantity Theory of Money and Prices enunciated by Wicksell. That is, the
sole source of investment is current savings. When investment demand
increases over and above current savings, price pressure sets in. Government
steps up the supply of money, but in so far as the rate of increase of money
supply is exactly equal to the rate of change in prices, the real money supply
remains unaffected. The price increases are temporary in nature and last
until investment and savings are again brought into equilibrium. (See W.
Leontief, 'The Consistancy of the Classical Theory of Money and Prices',
Econometrica (Jan 1950).
19. M. A. Choudhury, An Islamic Social Welfare Function (Indianapolis, Ind:
American Trust Publications, Jan 1983).
20. Milton Friedman expresses his critique of the Keynesian preoccupation with
short-run analysis in the following words, 'he [Keynes] was something of a
fine-tuner, that he tended to neglect the cumulative effect of short-run
policies. The truth in the long run we are all dead needs to be balanced by the
equally relevant truth that the long run consists of a succession of short
runs.' (See 'The Keynes Centenary: A Monetarist Reflects', The Economist, 4
June 1983.)
21. The case of the Islamic labour market is likened to the classical labour
market, which holds that in equilibrium wages would adjust in ways
adequate to clear this market by bringing demand in equality with supply.
This is, of course, based on the assumption of perfect competition. The
classical labour market thereby determines flexible real wages for which the
full-employment condition is attained and output corresponds to this
condition.
In the Islamic labour market the assumption of perfect competition is not
required. Real wages are not determined by the marginal productivity
condition. It is the property of determinate changes in the price level that
determines the flexible real wage consistent with full-employment
equilibrium.
12 TOWARDS A METHODOLOGICAL DEVELOPMENT OF ISLAMIC

ECONOMIC THEORY
1. M. P. Todaro, Economic Development in the Third World (New York:

Longmans, 1977).
2. P. Daniel, 'Accelerated Development in Sub-Saharan Africa: an Agenda for
Structural Adjustment Lending', Institute of Development Studies Bulletin,
vol. 14, no. 1 (1983).
3. L. Emmerij, 'The New Conservatism in the West', Third World Quarterly,
vol. 4, no. 3 (July 1982).
4. M. Friedman, Capitalism and Freedom (Chicago: University of Chicago
Press, I 962).
5. I. Sachs, 'The Crisis of the Welfare State and the Exercise of Social Rights to
Development', International Social Science Journal, vol. XXXIV, no. 1
(1982).
6. P. Blyton, 'Reorganizing Working Time', International Social Science
Journal, vol. xxxii, no. 3 (1980).
7. L. Emmerij, 'Basic Needs and Employment-oriented Strategies
Reconsidered', in R. P. Misra and M. Honjo, eds, Changing Perception of
Development Problems, vol. 1 of Regional Development Series, (Nagoya,
Japan: United Nations Centre for Regional Development, 1981).
8. R. J. Stephens, 'Social Economics: A Budding Scientific Research
Programme?', International Journal of Social Economics, vol. 8, no. 3
(1981).
9. A. Gray, The Development ofEconomic Doctrine (London: Longman, 1967)
chap. iv.
10. J. A. Schumpeter, History of Economic Analysis (New York: Oxford
University Press, 1968) chap. 2.
11. L. T. Sun, 'Religious Values and Public Choice: Social Justice Aspect'
Humanomics, vol. 1, no. 1 (1985).
12. R. H. Tawney, The Acquisitive Society (New York: Harcourt, Brace &
World Inc., 1920).
13. A. F. McKee, 'Social Economics and Social Values', International Journal
of Social Economics, vol. 9, no. 6/7 (1982).
14. J. C. O'Brien, 'Social Values, Social Goals and Manpower', (mimeo.),
School of Business and Administrative Science, California State University
at Fresno, August 1983.
15. N. Nordhaus, and J. Tobin, Economic Growth (New York: National Bureau
of Economic Research, 1982).
16. J. Greenberg, Social Indicators in Education: A Conceptual Framework,
Discussion Paper No.6 (Ottawa: Economic Council of Canada, Jan 1974).
17. A similar general equilibrium social welfare maximisation problem is given
in Microeconomic Theory: A Mathematical Approach (New York: McGraw-
Hill Inc., by J. M. Henderson and R. E. Quandt 1980, chap. 9. Also refer to
I. M. D. Little and J. A. Mirrlees, Project Appraisal and Planning for
Developing Countries (New York: Basic Books, 1974).
18. I. IIIich, The Right to Useful Unemployment (London: M. Bayars, 1977).
19. M. A. Choudhury, From Growth to Development Manifestofor the South,
Publication no. 165, (Institute of Development Studies, North-West

Frontier Province Agricultural University, Pakistan, June 1984).
20. Organisation for Economic Co-operation and Development, World
Economic Interdependence and the Evolving North-South Relationship (Paris,
1983).
21. The idea has been developed in M. A. Choudhury's completed work, Social
Economics of Manpower (mimeo), Department of Sociology, Ontario
Institute for Studies in Education, Toronto, June 1985.
22. M. A. Choudhury, 'Educational Planning and Economic Development in
Islamic Perspective', Muslim Education, vol. I, no. I {I 983).
23. The approach of the input-output model is based on average productivity,
i.e. fixed technological coefficients. This is in contrast to the marginal
approach of the neo-classical school.
24. R. A. Gordon, Goals of Full-Employment (New York: Wiley & Sons, 1967).
25. S. N. H. Naqvi, 'Ethical Foundations ofIslamic Economics, Islamic Studies
(Summer 1978).
26. M. A. Choudhury, An Islamic Social Welfare Function (American Trust
Publications, Jan 1983), preface.
27. --'Principles ofIslamic Economics', Middle Eastern Studies, vol. 19, no. 1
(Jan 1983).
28. M. Iqbal and M. F. Khan, A Survey of Issues and a Programmefor Research
in Monetary and Fiscal Economics of Islam, (Jeddah, Saudi Arabia:
International Centre for Research in Islamic Economics, King Abdulaziz
University and Institute of Policy Studies (Islamabad, Pakistan, Aug 1981).
29. See the proceedings of the First, Second and Third International
Conferences on Islamic Economics held at Makkah (Saudi Arabia) in 1976,
and Islamabad (Pakistan) in 1981 and 1983.
30. A. Saud, 'Money, Interest and Qirad', in Studies in Islamic Economics, ed.
K. Ahmed (International Centre for Research in Islamic Economics, King
Abdulaziz University, and the Islamic Foundation, U.K., 1980).
31. M. Uzair, 'Some Conceptual and Practical Aspects of Interest-free
Banking', in Studies in Islamic Economics ed. K. Ahmed (Leicester: Islamic
Foundation, 1980).
32. M. N. Siddiqui, Banking Without Interest (The Islamic Foundation,
Leicester, U.K., 1983). Also refer to V. Nienhaus's comments on M.
Siddiqui's book, published in the Journal of Research in Islamic Economics,
vol. I, no. 2 (Winter 1984).
33. M. Kahf, The Islamic Economy: An Analytical Study of the Functioning of
the Islamic Economic System (Plainfield, Ind.: The Muslim Students'
Association of the U.S. and Canada, 1980). Also refer to the comments of
U. M. Chapra published in the Journal of Research in Islamic Economics,
vol. I, no. 2 (Winter 1980).
34. M. A. Zarqa, 'Social Welfare Function and Consumer Behaviour: An
Islamic Formulation of Selected Issues', in Studies in Islamic Economics, op.
cit.
35. S. N. H. Naqvi, Ethics and Economics: An Islamic Synthesis (The Islamic
Foundation, U.K., 1981).
36. K. Ahmed, 'Economic Development in an Islamic Framework', in Studies
in Islamic Economics, op. cit.
M. R. Sharif, 'The Concept of Development in Islam' (mimeo.)

(International Centre for Research in Islamic Economics, 1983).
37. See, for example, M. P. Todaro's, Economic Development in the Third World
(New York: Longman, 1977); and P. Streeten's, Development Perspectives
(New York: St Martin's Press, 1981).
38. M. A. Mannan, 'Islamic Economics as a Science' (Research in Progress),
Journal of Research in Islamic Economics, vol. I, no. I (Summer 1983).
39. J. N. Bhagvati, 'Why There is No Mileage Left in Global Negotiations',
World Economy, vol. I, no. 2 (June 1983).
40. This thesis on the primary role of pervasive events and policies in the
development of economic theory is expounded by G. J. Stigler in his 'The
Influence of Events and Policies on Economic Theory', American Economic
Review (May, 1960).
41. M. Blaug, Economic Theory in Retrospect (Homewood, Ill. Irwin, 1968).
'Introduction: Has Economic Theory Progressed?'
42. S. S. Alexander, 'Mr. Keynes and Mr. Marx', Review of Economic Studies
(Feb 1940).
43. G. J. Stigler, 'The Influence of Events and Policies on Economic Theory',
American Economic Review (May 1960).
44. M. A. Choudhury, An Islamic Social Welfare Function (Indianapolis, Ind.:
American Trust Publications, Jan 1983) chaps. ii-iv.
45. --'The Rate of Capitalization in Valuation Models in an Islamic
Economy, in Fiscal Policy and Resource Allocation in Islam, ed. Z. Ahmed,
et al., (International Centre for Research in Islamic Economics, Jeddah,
Saudi Arabia, and Institute of Policy Studies, Islamabad, Pakistan, 1983).
46. The methodology developed in the rest of the work is similar to that
developed by G. Debreu in his Theory of Value: An Axiomatic Analysis of
Economic Equilibrium (New York: Wiley & Sons, 1965).
47. The Quran speaks of people of varying levels of Islamic faith who inhabit an
Islamic society at any time-people of very high levels of belief, people who
have just ordinary levels of belief, people who are hyper-critical of faith.
Then there are the non-Muslims, who are free to follow their own faiths.
48. R. Saposnik, and J. Quirk, Introduction to General Equilibrium Theory and
Welfare Economics (New York: McGraw-Hill Inc., 1968).
49. M. Morishima, Walras' Economics (Cambridge: Cambridge University
Press, 1977) chap. i.
50. J. M. Henderson, and R. E. Quandt, Microeconomic Theory: A
Mathematical Approach, (New York: McGraw-Hill Inc., 1971) chap. 2.
51. This form of the social welfare function is discussed by O. Lange in his
article, 'The Foundations of Welfare Economics', Econometrica, vol. 10
(1942).
52. Similar works are now in progress by A. N. Rugina: 'Principia Oeconomica:
In Search of a Scientific Foundation for Social Ethics' (mimeo.)
(Department of Economics, Northeastern University, 1984). Also refer to
the works by A. R. Gordon, Goals of Full-Employment; K. Dopfer's,
'Introduction: Towards a New Paradigm'; H. Liebenstein's 'Micro-Micro
Theory, Agent-Agent Trade, and X-Efficiency'; S. Tsuru's, 'Towards a
New Political Economy'. All these are published in Economics in the Future:
Towards a New Paradigm, ed. K. Dopfer (Boulder, Colo.: Westview Press,
1976).
Subject Index
aggregate production function, 124, social, 53, 59-{j1, 88, 90
182 total, 59-{j1, 94-5, 98, 118
average productivity and sectoral dis-
tribution of resources, 166-7, discount rate
197 as Islamic substitute for the rate of
interest, 22, 65, 81, 102-7, 137
benefit capital valuation with, 105-7, 133-
private, 59-{j1, 90 8
social, 53, 59-{j1, 88,90 distribution
total, 59-{j1, 95-{j, 98 concept of, 7, 8-11, 13-14
bliss, Ramsey and Islamic bliss points of income, 13-14, 28, 53-8, 89,
compared, 31-2 109-11, 140, 151, 153-8, 163,
bonds, see stocks 167, 197, 203, 206, 208
of wealth, 14, 18,53-8
cash balances dividend
and demand for money, 16, 172-5 and mudarabah, 36, 41-50, 72-84
precautionary motive for holding from joint venture, 41-2, 72-84,
money, 176 169,172,173, 174
and profit-liquidity trap, 174-5
and speculation motive for holding economic
money, 176 co-operation, 11-13, 166-7, 196
and transaction motive for holding competitive-co-operative con-
money, 176 ditions, 21, 34-9, 197
cash-flows, 90, 98 decree
consumer demand homo economicus, 2, 7, 8, 21
assumptions, 23-4 moral philosophy and the age of
function, 21, 22-32 Enlightenment, 3
consumption natural law, 3, 24, 117, 194-5
consumption -investment menu in non-homo economicus, 199-200
Islam, 17,27,43,94, 117, 135 positive law, 194-5
function, 116, 121, 140-{j5, 198 development
theory of, xiv, 17, 141-2 and social welfare, 192-{j
theory of interest, 135, 138 human resources and, 196
cost theory, 192, 198, 204
average, 34-9 with appropriate technology,
function, 34-7 196, 208
marginal, 38-9, 90, 124 with basic needs, 167, 193
of capital, 15, 42 with Third World self-reliance,
private, 59-{jl, 90 196
237
238 Subject Index
economic models, 61-7,70, 196, 198

equilibrium and inflation trade-off, 193, 196
existence of, 212 ethics
general (also macroeconomic), and economics, see social econ-
xiv, 2, 4, 68,119,121,172,183-6, omics under economics
200, 203, 207 and social welfare, 198, 208
in microeconomics, 33-39, 52, general equilibrium in ethical econ-
73-86, ItO, 197 omics, xv, 189, 208
of expenditure sector, 177-182. macroeconomic foundations of, xv,
oflabour market, 182-3 191, 195,207
of monetary sector, 174-7 microeconomic foundations of, xv,
rationality, II, 21, 23-5, 62, 88, 189, 191, 195,206,208-9
145, 197 theory of economics and, 192-201
and irrationality, 21, 24-8 Euler's equation, 37, 39
assumptions of, 23-4
critique of, 24-5 financial statements
theory and mudarabah, 41-50
and policy, 7, 11, 14-18, 58, 90, and zakah, 43, 46
163, 167, 186, 201, 202, 205-7, for the conventional firm, 21
216 for the Islamic firm, 21
definition, 2-3, 166 fixed-point theorems, 212
Islamic, 1-4, 207 -16
economics imponderables
classical, 2, 21, 52, 206 in benefit functions, 95-6
Islamic, xiii-xv, 1,4,7-19,94,189, in consumer preferences, 25, 203,
191, 199-205 209
Keynesian, 2, 7, 112, 128, 138, 147, in cost functions, 94, 95
179-80, 182, 186, 193-4,206 in utility functions, 22, 26-31,96-
mainstream, xiii-xv, 21, 22, 25, 121, 100
189, 194-6 in welfare functions, 26, 99-106,
~arxian, 2, 138, 208 116
neo-classical, 2, 17, 21, 25, 99, 121, investment
124-7, 192-6 and mudarabah, 72-86, 104, 133,
social, xiii-xv, 21, 22, 189, 191, 139
194-200 and zakah, 13-14, 100-6, 135
efficiency consumption-investment menu, see
allocative, 12-13, 15, 17, 53, 75, under consumption
126, 193, 197 function, 179, 198
and equity trade-off, 196 oriented welfare functions, 100-7
first order conditions of economic, theory of, xiv, 121, 123-39
33-9 theory of interest, 132-3
marginal (of capital), 76-7, 117, Islamic
128, 132, 135-8, 173, 183, 206 arabic terminology (also refer to the
with altruism, 26-32 list of meanings of arabic trans-
X-efficiency, 54, 71, 75, 197 literation, pp. xvi-xvii)
employment akhira, 22, 53, 93, 94-5, 115-19
and inflation in macroeconomic al-Afw, 143
models, 182-6, 193, 198 al-Hisbah, 1l7-18
and inflation in microeconomic Bait al-~al, 14
Subject Index 239
fai,9 zakah,3,9, 10, 13-14, 18,21,22,

fidth,9 27,28,29,43,46,51-71,93,94,
fiqh, 10 100-2, 118, 135, 140-41, 146,
ghanimah, 9, 10 147-8, 152, 154-65, 170-86,
hadith,9, 10, 130 202, 208, 211
haram, 115-16 institutions
ibadah, 3, 22, 65, 112-16,200 Bait aI-Mal, 14
ihsan, 118 Dar al-Mal-al-Islami (OMI), xiv
ijma, 22, 114, 119 investment companies, xiv, 72,
ijtehad, xiii, xiv, 114, 119, 129, 205
207 Islamic banks, xiv, 15, 16, 72, 173,
islah, 118 174, 180, 201, 205
israf, 17, 73, 94, 115, 162, 164, Islamic Development Bank (lOB),
169, 170, 200, 208, 214 xiv, 72, 205
kharaj,9 Organisation of Islamic Con-
la israf, 4, 115-17,209 ferences (OIC), 204-5
mafasid, 118-119 IS-LM schedule, 174-81, 183-6
maqasid al-shariah, 93 welfare state, 58, 111-13, 119, 216
masalih, 119
mua'malat, 3, 112 labour
mudarabah, 13, 15-17, 21, 22, and employment, 17l, 182-3,
34, 36, 37, 41-3, 46, 47, 72-86, 185,206
131, 169-74, 200, 208
and human capital formation, 59-
muhtasib, 117
67, 70, 100-2, 182
mujtahid, 114, 119
Lagrange multiplier, 35, 82, 85, 101,
musharakah (also masharakah), 104
15,200,208
nisab (also an-nisab), 9, 10, 15,
51, 55, 60, 62, 65, 149 mathematical
qard-i-hasan, 146 economic set of
Quran, xiii-xiv, 1,9, 10, 14, 58, consumption, 109-10, 209
93,112,114,119,128,131,137, ethical imponderables, 210-11
143-6,160-61,168, 178,200 individual preferences, 209
riba, 11-12, 14-15,40, 128-31, isoquants, 210
137-9, 169,200 mappings, 211-15
risalah, 53 production, 109-10, 210
rububiyyah, 8 Islamic economic model of
sadaqah, 9, 94 consumption, 148-65, 178-9
salah,54 cost-benefit, 63 -70
shariah, xiv, 3, 10,21,22,29,98- decision-making, 89-91,94-106
9,111-13,114-19,204 ethico-economic general equilib-
shirakah (also shirkah), see rium, 213-216
musharakah investment, 133 -8, 177-8
sunnah, xiii-xiv, 119, 146, 160- macroeconomic general equilib-
61,200 rium, 183-6
taqwa, 22, 93, 95, 115-19, 143, pricing for the firm, 34-9
200 profit-sharing, 81-6
tawheed, 8, 10, 11, 53, 112-13 social service, 51, 59-61
ushr, 9 social welfare, 89-106
240 Subject Index
money rate
and the rate of interest, 15-16, 172, of capitalisation, see under discount
173-80 rate
demand for, 16,76,80, 128, 172-7 of interest, see under riba in Islamic
monetary policies, 16, 77, 181, 201- terminology
2 of return, 65-8, 71, 106-7,202
motives for holding, 176-7, 179- redistribution
81, 206 of income, 3,9-11,27,29,53-8,93,
supply of, 16, 77, 80, 128, 172-3, 168,202
176-7 of wealth, 9-11, 18,53-8, 168,202
multiplier theory of, 9-11, 13-14
income, 13-14, 55, 62, 69, 186 resource allocation, xiv, 2, 7, 8, 12-13,
investment, 14, 55 17,21,22,26,28,29,39,51-71,
social welfare, 63, 66, 102-3 88,92,93-8, 108-10, Ill, 121,
126, 134, 140, 143, 147, 150, 166,
optimality 193, 201, 204, 206, 210
and equilibrium, 73-86 risk
Hamiltonian and dynamic optimis- and mudarabah, 16-17
ation, 104 aversion, 73, 79, 81, 92, 103-5
optimisation, 22, 23, 35-7,43, 50, diversification, 16,22,42, 72-86
82,84-6,88, 100-6, 196, 197-8 pricing, 75-86, 105
optimum, 44-50, 74-86 sharing, see under musharakah in
output Islamic terminology
as externality, 53, 75, 90, 91, 101,
196, 197 savings, 15, 63-8, 153-8, 163, 165,
as GNP, 192, 195-6 177-9
as value added, 44 Slutsky'S equation, 32
stocks, 21, 40-50
production
aggregate, see under aggregate pro-
duction function time-preference
menu, 197 -8, 208 critique of the theory of, 99
firm's 34-9, 210, 216 social time-preference rate, 116-17,
productivity 132, 135, 138
of capital, 124-5, 134 theory of, 128, 200
oflabour, 8, 12-13, 16,52,65,69-
70,95,96, 124-5, 168, 172 utility
marginal, 37, 39, 52, 123-5, 167, atemporal utility function, 98-100,
183, 197 115
profit function, 12, 23, 32, 63, 78, 81-6,
normal rate of, 34, 74, 76, 79, 81, 84, 88-91, 110-11, 116-17, 148-9,
121,169,173 197, 203,214-15
rate of, 11, 15,37,41-50,76,84, interdependent, 26, 28, 74-86, 197
125, 128, 134, 138, 169, 173-4, Islamic concept of time in, 96-8
183 marginal, 2, 12,75,78,89, 109, Ill,
sharing rate (also rate-ratio), 73-84 149
profit-sharing, see under mudarabah maximisation of, 8, 22, 23, 26, 52
in Islamic terminology utilitarianism, 2, 24, 117, 195
Subject Index 241
welfare social choice and, 17, 22, 92, Ill,

economics, xiv, 4, 17, 22, 79, 87, 113-20, 203, 207
108-10, 117-18, 197,203,207 state, xiii, 193
function, 4, 54, 63, 91, 92, 98-106,
110-11, 115-21, 196, 202, 208,
213-16

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AN ISLAMIC SOCIAL WELFARE FUNCTION

A Study in Social Economics

Masudul Alam Choudhury

All rights reserved. For information, write:

First published in the United States of America in 1986

Library of Congress Cataloging-in-Publication Data

Introduction: Towards a Definition of Islamic Economic

PART III MACROECONOMICS 121

PART IV POSTSCRIPT 189

MASUDUL ALAM CHOUDHURY

Part IV constitutes the Postscript on a methodological development

la israf not to consume in waste

analysis are of recent origin. They owe their development in the

Schumpeterian caveats apart, the fact remains that economic science

fa israf, meaning the Islamic religious constraints on Muslims against

PRINCIPLES OF ISLAMIC ECONOMICS

The Principle of Tawheed and Brotherhood

Islamic economics is not content with the conventional viewpoint of

The Principle of Work and Productivity

The second basic principle of Islamic economics is that of work and

proprietorship of the means of production. Because Islamic economic

The Principle of Distributional Equity

The third major principle of Islamic economics is the right of society to

ANALYTIC IMPLICATIONS OF THE ISLAMIC ECONOMIC

The viability of the three major principles ofIslamic economics must be

Analytic Implications of Principle of Tawheed and Brotherhood

In order to establish the principle of tawheed and Brotherhood, Islam

lawful is therefore, to be considered as a limit to the ownership of the

Analytic Implications of the Principle of Work and Productivity

In the framework of a pure exchange economy it can be shown that the

economic second-best solution is indeed a more realistic state of the

Analytical Implications of the Principle of Distributional Equity

The analytical relations developed by the author elsewhere 11 on the

POLICY BASIS OF THE ISLAMIC ECONOMIC PRINCIPLES

ventures; (3) the abolition of israf, meaning wasteful consumption, and

Islam categorically disapproves of the existence of interest in all

In the absence of interest in economic transactions Islamic banks would

system the Islamic banks would not be in a position to create unlimited

available for consumption expenditure, but only to a certain desired

Excessive or wasteful consumption, be it of necessaries, comforts or

One of the most important Quranic injunctions on Muslims is the

The foregoing has been a brief outline of the principles of Islamic

shaping of a new development programme for Muslim nations if they

The theory of consumer demand is steeped in the postulate of economic

the consumer is said to prefer A to B. Thus, for all possible pairs of

A CRITIQUE OF THE POSTULATE OF ECONOMIC

The concept of economic rationality has been the target of intense

imparts a message of vital importance to Islamic economic theory of

AN ISLAMIC THEORY OF CONSUMER DEMAND

In the Islamic economic theory of consumer demand 'imponderables',

proxies for such invisible prices can be imparted by assigning ordinal

presence of 'irrational' consumer behaviour in the sense defined earlier,

words of an Islamic writer: 'The basis of an integrative or systematic

goods, not necessarily for self-consumption, rather for gaining felicity

FIGURE 2.1 Price-quantity relationship in an Islamic framework. and

Our earlier formalisation of the demand configuration in the presence

individual, as in the case of the Islamic consumer behaviour, bliss is

Economics is traditionally defined as a study of scarcity of resources and

THE BASIS OF A COMPETITIVE-CO-OPERATIVE

PRICING THEORY OF THE FIRM IN AN ISLAMIC ECONOMY

inordinate amount of profits through monopolistic competition and