ALLAMA IQBAL OPEN UNIVERSITY, ISLAMABAD

(Department of Business Administration)

Course: Economic Analysis (5001)

Level: MBA Semester: Autumn, 2020
Total Marks: 100
Pass Marks: 50
ASSIGNMENT No. 1

Q.1 Explain Islamic Economic System. Discuss the features of Islamic Economic System
over the Capitalist and socialist Economies.
Property
In the Islamic system, property is a trust. The real owner is Allah (Subhanahu Wa Ta’ala).
Man’s disposal of worldly goods is in the capacity of a viceroy and a trustee. His rights are,
therefore, circumscribed by the limits Allah has prescribed, and should be exercised
toward the ends Allah has defined. Unlike the capitalist system, the right to property is not
absolute but has limitations and qualifications enforced not by the power of the
government but by the power of one's faith and desire to be a pious Muslim. Hence, the
common-good and the welfare of fellow Muslims are internalized in the decision making
process of every Muslim. It is Socialism with at the state.
In view of the purposive nature of man's life in the Islamic world view, even these limited
rights of ownership are not devoid of purpose. Wealth is an instrument in the effective
discharge of man responsibilities as the viceroy of Allah, and the achievement of well-
being in the life for himself, his fellow Muslims and fellow human beings. No where this
viceroyship is displayed like in the Shari’ah laws of inheritance. These laws clearly assume
that once the individual is dead, his wealth goes back to the original owner, who specifies
to whom the wealth should go. The laws of inheritance specify where exactly this wealth
should go, regardless of the approve or the consent of the deceased owner. He is
permitted to endow only 1/3 of his legacy. Even then, such endowment should not go to a
beneficiary (one also is included in the inheritors) not to uses that are not considered is
Shari’ah a charity.
Distribution

Because al-adl (justice and fairness) is a basic value of the Islamic economic order,
distributive justice is a major concern of the system. Equitable distribution of income and
wealth is therefore an objective by itself. Operationally, this is accomplished through
certain institutions which form the backbone of the social security in Islam. Examples are a
bound:
Zakah

Zakah is the third pillar of the Islamic faith. It is a unique system of social security. Zakah is
not a hand-out from the rich to the poor. It is a right of the have nots in the wealth of the
haves. It is a measure designed to directly transfer part of the wealth from the well-to-do
to the poor and not to the government. Because the purpose is redistribution of income
and wealth, without creating a class society zakah is levied on almost every one. Even the
not very well to do, pay zakah. He may then receive the zakat of others at the same time.
Zakah is levied annually on the wealth itself and not on the individual or income, at a
general rate of 2½ % per annum. This is not all. Zakah is a requirement. However, a Muslim
is always engaged not to confine his charity to that requirement by giving alms (sadaqat).
Laws of Inheritance

It would not be possible to guarantee the functioning of the system free from injustices
without a built-in-mechanism to prevent injustice reproducing itself generation after
generation. Studies show that one of the major causes of inequality in income distribution,
is the distribution of wealth. One major outcome of the Islamic laws of inheritance, is to
prevent concentration of wealth. This is because legacy is distributed in a pre-set ratios
which take into consideration need and closeness to the deceased. Yet giving the deceased
the right to assign part of his wealth (not exceeding 1/3) to charitable uses.
Economic Freedom

Freedom is a cornerstone in the Islamic economic system. In fact, it is so basic that the
whole message of Islam came to free man from all kind of slavery. Freewill is a necessary
condition for the validity of all contracts. The basic human rights which are now included
in the laws of civilized countries has been a part of legal system of Islam since the Prophet
(P.B.U.H ) . In fact, all the so called Magna Charta has been enjoyed as the basic individual
rights in Islam for centuries. Furthermore, to guarantee competition in the marketplace
and freedom of transaction, many measures were adopted by the Prophet (P.B.U.H).
Prohibition of monopoly, manipulation of prices and restricting entry to the market are
but a few of these measures.
The Islamic Economy is Interest-Free

Today’s trade and commerce in the whole world is run on the basis of interest based debt.
If we look at the money and capital markets in any country we find that they are basically
markets for exchanging financial obligations and receivables. It is no wonder that just the
mere thought that interest rate may go up (or down) will bring havoc to all sectors of the
economy. Standard economic analysis tells that interest rates play important roles in the
economy. Firstly, that it provides incentives for savings, and secondly that it performs an
allocative function with regard to capital. The argument goes as follows:

1. Saving is essential to any economy because on which depends the rate of

investment, and hence the rate of growth of the economy and the property of its
citizens. Since economic development is the objective of every society, improving
the nascent rate of saving becomes a basic requirement for the achievement of a
viable and sustainable economic growth. Because too much saving may be just as
unproductive as too little, interest rates, furthermore, provide a tool for policy as
regards savings where this rate is controlled in such a way as to attain the right
magnitude of savings as required by the going economic circumstances.
2. As regards the distributive function of interest, it is believed that interest rate plays
a yardstick (benchmark) for evaluating the feasibility of investment projects and
other uses of scarce resources. Since capital is scarce, the economy need a tool
through which this resource is directed to the best use, i.e. the one that produces
the highest returns. Without such a tool, it is quite possible to see capital going to
 relatively poor projects, while the sound ones are left out of investment capital.
With the tool of interest rate, expected profits are always compared to the rate of
interest. Since the latter measures the cost of capital, only these projects which
make more returns than “cost” will be financed. Even self financing will be subject
to such a benchmark since interest plays an “alternative” to any investment
opportunity (i.e. an opportunity cost)

Q.2 Explain law of Demand. Critically discuss the law of demand and its practical
implications on the common person of the society.

ANS: The law of demand is one of the most fundamental concepts in economics. It works
with the law of supply to explain how market economies allocate resources and determine
the prices of goods and services that we observe in everyday transactions. The law of
demand states that quantity purchased varies inversely with price. In other words, the
higher the price, the lower the quantity demanded. This occurs because of diminishing
marginal utility. That is, consumers use the first units of an economic good they purchase
to serve their most urgent needs first, and use each additional unit of the good to serve
successively lower valued ends.

• The law of demand is a fundamental principle of economics which states that at a

higher price consumers will demand a lower quantity of a good.
• Demand is derived from the law of diminishing marginal utility, the fact that
consumers use economic goods to satisfy their most urgent needs first.
• A market demand curve expresses the sum of quantity demanded at each price
across all consumers in the market.
• Changes in price can be reflected in movement along a demand curve, but do not by
themselves increase or decrease demand.
• The shape and magnitude of demand shifts in response to changes in consumer
preferences, incomes, or related economic goods, NOT to changes in price.
Law of Demand
Economics involves the study of how people use limited means to satisfy unlimited wants.
The law of demand focuses on those unlimited wants. Naturally, people prioritize more
urgent wants and needs over less urgent ones in their economic behavior, and this carries
over into how people choose among the limited means available to them. For any
economic good, the first unit of that good that a consumer gets their hands on will tend to
be put to use to satisfy the most urgent need the consumer has that that good can satisfy.

For example, consider a castaway on a desert island who obtains a six pack of bottled,
fresh water washed up on shore. The first bottle will be used to satisfy the castaway's
most urgently felt need, most likely drinking water to avoid dying of thirst. The second
bottle might be used for bathing to stave off disease, an urgent but less immediate need.
The third bottle could be used for a less urgent need such as boiling some fish to have a
hot meal, and on down to the last bottle, which the castaway uses for a relatively low
priority like watering a small potted plant to keep him company on the island.

In our example, because each additional bottle of water is used for a successively less
highly valued want or need by our castaway, we can say that the castaway values each
additional bottle less than the one before. Similarly, when consumers purchase goods on
the market each additional unit of any given good or service that they buy will be put to a
less valued use than the one before, so we can say that they value each additional unit less
and less. Because they value each additional unit of the good less, they are willing to pay
less for it. So the more units of a good consumers buy, the less they are willing to pay in
terms of the price.

By adding up all the units of a good that consumers are willing to buy at any given price we
can describe a market demand curve, which is always downward-sloping, like the one
shown in the chart below. Each point on the curve (A, B, C) reflects the quantity demanded
(Q) at a given price (P). At point A, for example, the quantity demanded is low (Q1) and the
price is high (P1). At higher prices, consumers demand less of the good, and at lower
prices, they demand more.
Demand vs Quantity Demanded
In economic thinking, it is important to understand the difference between the
phenomenon of demand and the quantity demanded. In the chart, the term "demand"
refers to the green line plotted through A, B, and C. It expresses the relationship between
the urgency of consumer wants and the number of units of the economic good at hand. A
change in demand means a shift of the position or shape of this curve; it reflects a change
in the underlying pattern of consumer wants and needs vis-a-vis the means available to
satisfy them. On the other hand, the term "quantity demanded" refers to a point along
with horizontal axis. Changes in the quantity demanded strictly reflect changes in the
price, without implying any change in the pattern of consumer preferences. Changes in
quantity demanded just mean movement along the demand curve itself because of a
change in price. These two ideas are often conflated, but this is a common error; rising (or
falling) in prices do not decrease (or increase) demand, they change the quantity
demanded.

Factors Affecting Demand

So what does change demand? The shape and position of the demand curve can be
impacted by several factors. Rising incomes tend to increase demand for normal economic
goods, as people are willing to spend more. The availability of close substitute products
that compete with a given economic good will tend to reduce demand for that good, since
they can satisfy the same kinds of consumer wants and needs. Conversely, the availability
of closely complementary goods will tend to increase demand for an economic good,
because the use of two goods together can be even more valuable to consumers than
using them separately, like peanut butter and jelly. Other factors such as future
expectations, changes in background environmental conditions, or change in the actual or
perceived quality of a good can change the demand curve, because they alter the pattern
of consumer preferences for how the good can be used and how urgently it is needed.
Q.3 Critically discuss the relationship between elasticity of demand and the revenue
with examples.

ANS: Price elasticity of demand describes how changes in the price for goods and the
demand for those same goods relate. As those two variables interact, they can have an
impact on a firm’s total revenue. Revenue is the amount of money a firm brings in from
sales—i.e., the total number of units sold multiplied by the price per unit. Therefore, as
the price or the quantity sold changes, those changes have a direct impact on revenue.

Businesses seek to maximize their profits, and price is one tool they have at their disposal
to influence demand (and therefore sales). Picking the right price is tricky, though. What
happens with a price increase? Will customers buy only a little less, such that the price
increase raises revenues, or will they buy a lot less, such that the price increase lowers
revenues? Might the company earn more if it lowers prices, or will that just lead to lower
revenue per unit without stimulating new demand? These are critical questions for every
business.

In this section, you’ll learn more about how firms think about the impact of price
elasticities on revenue.

The specific things you’ll learn in this section include the following:

• Explain the interaction between price and revenue, given elastic demand
• Explain the interaction between price and revenue, given inelastic demand
• Explain how changes in production costs affect price

Learning Activities

The learning activities for this section include the following:

• Reading: Elasticity and Total Revenue

• Reading: Elasticity, Costs, and Customers
• Self Check: Price Elasticity and Total Revenue
Q.4 Explain joint stock company. Critically discuss the advantages of Joint Stock
Company over partnership business.
Ans:
Joint Stock:
What Is a Joint-Stock Company?
The modern corporation has its origins in the joint-stock company. A joint-stock company
is a business owned by its investors, with each investor owning a share based on the
amount of stock purchased.

Joint-stock companies are created in order to finance endeavors that are too expensive for
an individual or even a government to fund. The owners of a joint-stock company expect
to share in its profits.

Advantages of Joint Stock Company:

1. Larger Capital- The huge capital required by modern enterprises would not be possible
under other forms of organisations like sole individual proprietorship and even in
partnership. The joint stock company by its widespread appeal to investors of all classes
can raise adequate resources of capital required by large-scale enterprise.

2. Limited Liability- Liability of the shareholders of a company is limited to the face value of
the shares they have purchased. It has a stimulating effect on investment. The private
property of shareholder is not attachable to recover the dues of the company.

3. Stability of Existence- The organisation of a company as a separate legal entity gives it a

character of permanence or continuity. As an incorporated body, a company enjoys
perpetual existence.

4. Economies of Scale- Since the company operates on a large scale, it would result in the
realisation of economies in purchases, management, distribution or selling. These
economies would provide goods to the consumer at a cheaper price.

5. Scope for Expansion- As there is no restriction to the maximum number of members in a

public company, expansion of business is easy by issuing new shares and debentures.
6. Public Confidence- Formation and working of companies are well regulated by the
provisions of the Companies Act. The provisions regarding compulsory publication of some
documents, accounts, director’s report, etc., create confidence in public. Their accounts
are audited by a chartered accountant and are to be published. This creates confidence in
the public about the functioning of the company.

7. Transferability of Shares- The shareholders of a public company are entitled to transfer

the shares held by them to others. The shares of most joint stock companies are listed on
the stock exchange and hence can be easily sold.

8. Professional Management- The management of a company vests in the directors duly

elected by shareholders. Normally, experienced persons are elected as directors. Thus, the
available skill is utilized for the benefit of the company. The company organisation,
therefore, is like a bridge between the skill and capital.

9. Tax Benefits- Company pays lower tax on a higher income. This is because of the reason
that the company pays tax on the flat rates. Similarly, company gets some tax concessions
if it establishes itself in a backward area.

10. Risk Diffused- The membership of a company is large. The business risk is divided
among several members of the company. This encourages investment of small investors.

Disadvantages of Joint Stock Company:

1. Difficulty in formation- The legal formalities and procedures required in the formation of
a company are many. It has to approach large number of people for its capital and it
cannot commence business, unless it has obtained a certificate of incorporation and a
certificate to commence business.

2. Lack of Secrecy- Every issue is discussed in the meeting of the board of directors. The
minutes of meeting and accounts of the firm’s profit and loss etc., have to be published. In
this situation maintenance of secrecy is difficult.
3. Delay in Decision Making- In company form of organisation, all important decisions are
taken by the board of directors and shareholders in general meeting. Hence, decision
making process is time consuming. Board of directors itself has often to be at the mercy of
bureaucracy.

4. Concentration of Economic Power- The company form of organisation gives scope for
concentration of economic power in a few hands. It gives easy scope for the formation of
combinations which results in monopoly. Large joint stock companies tend to form
themselves into combinations or associations exercising monopolistic power which may
prove detrimental to other firms in the same line or to the consumers.

5. Lack of Personal Interest- In company form of organisation, the day-to-day management

is vested with the salaried persons or executives who do not have any personal interest in
the company. This may lead to reduced employee motivation and result in inefficiency.

6. More Government Restrictions- The internal working of the company is subject to

statutory restrictions regarding meeting, voting, audit, etc. The establishment and running
of a company, therefore, would prove to be troublesome and burdensome because of
complicated legal regulations.

7. Incapable and Unscrupulous Management- Unscrupulous individuals may bring

economic ruin to the community by promoting bogus companies. The fraudulent
promoters may be fool the public to collect capital and misuse it for their personal gain.
Misuse of property, goods and money by the managerial personnel may harm the
interests of the shareholders and create panic among the investing public.

8. Undue Speculation in the Shares of the Company- Illegitimate speculation in the values
of shares of a company listed on the stock exchange is injurious to the interest of
shareholders. Violent fluctuations in the values of shares as a result of gambling on the
stock exchange, weakens the confidence of investors and may lead to financial crisis.
Q.5 Explain perfect market. Critically evaluate the assumptions and features of perfect
market with examples.

Perfect Competition – a Pure Market

• We can take some useful insights from studying a world of perfect competition and
then comparing and contrasting with imperfectly competitive markets and
industries

• Economists have become more interested in pure competition partly because of the
growth of e-commerce as a means of buying and selling goods and services. And
also because of the popularity of auctions as a device for allocating scarce resources
among competing ends.

What are the main assumptions for a perfectly competitive market?

1. Many sellers in the market - each of whom produce a low percentage of market
output and cannot influence the prevailing market price – each firm in this market is
a price taker - i.e. it has to take the market price
2. Many individual buyers - none has any control over the market price
3. Perfect freedom of entry and exit from the industry. Firms face no sunk costs and
entry and exit from the market is feasible in the long run. This assumption means
that all firms in a perfectly competitive market make normal profits in the long run
4. Homogeneous products are supplied to the markets that are perfect substitutes.
This leads to each firms being “price takers" with a perfectly elastic demand curve
for their product
5. Perfect knowledge – consumers have all readily available information about prices
and products from competing suppliers and can access this at zero cost – in other
words, there are few transactions costs involved in searching for the required
information about prices. Likewise sellers have perfect knowledge about their
competitors
6. Perfectly mobile factors of production – land, labour and capital can be switched in
response to changing market conditions, prices and incentives. We assume that
transport costs are insignificant
 7. No externalities arising from production and/or consumption

Understanding the real world of imperfect competition!

It is often said that perfect competition is a market structure that is out-dated not worthy
of study! Clearly the assumptions of pure competition do not hold in the vast majority of
real-world markets.

• Suppliers may exert control over the amount of goods and services supplied and
exploit their market power

• On the demand-side, consumers may have monopsony power against their

suppliers because they purchase a high percentage of total demand.

• In addition, there are always some barriers to the contestability a market and far
from being homogeneous; most markets are full of heterogeneous products due
to product differentiation

• Consumers have imperfect information and preferences are influenced

by persuasive marketing

• In every industry we can find examples of asymmetric information where the seller
knows more about quality of good than buyer – a frequently quoted example is the
market for second-hand cars!

• The real world is one in which negative and positive externalities from both
production and consumption are numerous – both of which can lead to a divergence
between private and social costs and benefits.

• Finally there may be imperfect competition in related markets such as the market
for key raw materials, labour and capital goods.

END
Edit by; Hayyat Afridi

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