ESSENTIALS OF ISLAMIC

FINANCE
Course Code: FIN381

Project on

Islamic Economic System

BY
SUMMYYA (27925)

Date of Submission: 26/07/2015

The Economic System of Islam

The Sources of Islamic Economics
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Summary
As a complete way of life, Islam has provided guidelines and rules for every sphere
of life and society. A functioning economic system is vital for people to realize their
material and other goals in life.
Islam has set some standards, based on justice and practicality, for such economic
systems to be established. These standards recognize money as being among the most
important elements in society; they do not lose sight of the fact that its position is
secondary to the real purpose of human existence, which is the worship of God.
When a society implements on Islamic Laws and manners, Social,
Economic, and so forth system is automatic generate and Islam teaches that God creates
provisions for every one that brought to life and organizes the relationship between the
individual and his Creator.
In that sense, Islam regulates human behavior, relate with economic behavior which
dealt by Muslims as a means of production, distribution, and consumption of goods and
services. In Islam, human behavior -whether in the economic area or others - is not value
free; nor is it value neutral.

The Sources of Islamic Economics

There are two fundamental sources of Islam - the Quran and the Sunnah of the
Prophet- provide guidelines for not only for how to spent life but also a blueprint of how
a society should be organized their economic behavior and system. The Islamic economic
system is defined by a network of rules called the Shariah. The Shariahs rules are both
constitutive and regulative. As an integral part of the revelation, the Shariah is the guide
for human action which encompasses every aspect of life spiritual, individual, social,
political, cultural, and economic. Thus there are five types of actions recognized, namely:
obligatory; recommended; permissible; discouraged; and forbidden. The Sunnah further
explains these rules by the practical application of Prophet Muhammad, may the mercy
and blessings of God be upon him. The expansion of the regulative rules of the Shariah
and their extensions to new situations in later times was accomplished with the aid of
consensus of the scholars, analogical reasoning - which derived rules by discerning an
analogy between new problems and those existing in the primary sources.
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Justice
Islamic Economic system is based upon the notion of justice. Justice in Islam is a
multifaceted concept, and defined as acting in accordance with the Shariah and there
several words exist to define it and the most common Arabic word adl. This word and
its many synonyms imply the concepts of right, as equivalent to fairness, putting
things in their proper place, equality, equalizing, balance, temperance and
moderation. Justice contains both substantive and procedural justice covering
economic issues. Substantive justice consists of those elements contained in the
substance of the Shariah, while procedural justice consists of rules of procedure assuring
the attainment of justice contained in the substance of the Law. The rules governing
permissible and forbidden economic behavior on the part of consumers, producers and
government, as well as questions of property rights, and of the production and
distribution of wealth, are all based on the Islamic view of justice.

The Ideological Basis of Economic Activity

The ideological basis in Islam may be summarized into six basic principles:
1) The cornerstone is that everything has to start from the belief in God as the
Creator, Lord, and Sovereign of the universe. And to accept His guidance, and
have complete and unqualified servitude to Him. This means that Muslims individually and collectively - should not follow or replicate any other system if it
differs from their particular principles, for example, interest.
2) Islam, as a religion, is a complete way of life: the moral, social, ethical, economic,
political, etc. All of these aspects are based on the guidance of God. Everything
has to be within that basic guidance.
And we have revealed to you in stages this book, a
clarification of all things, guidance, a mercy, and glad
tidings (Quran 16:89)
3) God created human beings on earth as His trustees, which means that everyone is
created to fulfill a certain responsibility on this earth. God has entrusted human

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beings with free will in order that they live their lives according to guidance that
He Himself provided.
4) God, in order to help humankind to fulfill the responsibility of trusteeship, has
made everything in this universe subservient to them.
God is He Who made subservient to you the sea that the ships
may run therein by His command, and that you may seek of
His grace, and that you may give thanks. (Quran 45:12)
This does not mean, however, that humans are given free reign to use and abuse
the resources God has provided us however we choose. Humans are encouraged to
enjoy of the good things that God has created, but they are to do so within the
boundaries that He has given. Doing so is not regarded as sinful as long as it
follows His path and does not transgress His limits. God says:
It is He Who produces gardens, with trellises and without, and
dates, and tilth with produce of all kinds, and olives and
pomegranates, similar (in kind) and different (in variety): eat of
their fruit in their season, but render the dues that are proper
on the day that the harvest is gathered. But waste not by
excess: for God loves not those who waste. (Quran 6:141)
5) Every single person will be questioned on the Day of Judgment as to how he or
she behaved whilst enjoying his or her earthly life. This, of course, includes our
economic behavior. God says:
And then on that Day (the Day of Resurrection) you will be
called to account for every comfort and delight [we bestowed
upon you]. (Quran 102:8)
6) The variation in wealth among people in itself does not give a person either
inferiority or superiority. Rather, poverty and affluence are in the total control of
God Who, out of His Infinite Justice and Wisdom, has specified these things for
whom he chooses.
Indeed God increases provision to whom He pleases and
straitens it [in regards to others] (Quran 13:26)

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Affluence, like poverty, is also seen as a trial from God, one through which it is
seen what one will do with their wealth, God says:
Your wealth and your children are only a trial, whereas God!
With Him is a great reward (Paradise).(Quran 64:15)
After being bestowed with numerous gifts and bounties and a kingdom
incomparable to any other on the earth, God in the Quran narrates that Solomon
said:
This is from the bounties of my Lord, to test me whether I
will be thankful or ungrateful (Quran 27:40)
The Prophet also said:
Indeed God is not concerned with your appearances nor your wealth, but
rather your hearts and deeds. (Saheeh Muslim)

In a capitalist society, one may see certain rules of economics which take precedence
over moral and ethical values due to the intrinsic nature and values of that system. The
same may be seen in communist, socialist and other societies as well. From the
principles mentioned in the Islamic system of economics spring, striking balance between
personal benefit and the benefit of society as a whole, as well as mundane profits and
spiritual gains, all which ensure that one gain the Pleasure of the Lord of the Worlds.

Islam and Environmental Economics

Salman Ahmed Shaikh (IBA Karachi)
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Summary
Philosophy of Islamic Economics

Islam is a code of life. Humans worldly life is a test. In order to perform this test, a
human has to depend on others, so Responsibilities and awards are given to him. Some
humans are rich and some poor, but both are part of this test. test are going to be judged
on the basis of how the obligations undertaken and how they use the rewards and thanked
God in all circumstances, and keeping ethical guidelines prescribed by their Creator for
them through an inherent conscience and through guidance provided via sending
Prophets (peace be upon them all).Humans are capable of using both material rationality
and moral rationality to differentiate right from wrong and need strengthening to adopt
virtues influenced by an inner urge other than just material interests.

History of economic man is interesting. He has used the natures blessings to find and
create new and innovative ways of maximizing utility but, not feel satisfied because they
have the limitless desires and natures limitations. But, then, everyone achieves it one day
where he is not accompanied by anyone (his or her grave). Belief in life hereafter is the
only thing that gives meaning to the human life and the most important pillar of Islamic
economics.

Market Mechanism in an Islamic Economy

In an Islamic economy, market mechanism is filtered by divine injunctions. All that
these divine injunctions do is to regulate certain actions, provide broad guidelines and
through which certain restrictions are imposed on humans for their own benefit.

Islam & Welfare Economics

In the mainstream economics, utility (satisfaction) is assumed to be attained when the
person consumes the goods and services which bring satisfaction. With belief in Allah, a
Muslim's scope of life and objective is different. His principal goal is make every

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decision in a way to seek Allah's pleasure and succeed in the life hereafter rather than
pursuing self-pleasure as an end in itself.
Hence, the fact is material resources they enjoy are all blessings of Allah and these
are instruments for this test.
Islamic economics incorporates ethical values and eliminates from the consumption
bundle various goods which bring either private loss or welfare loss to the society. And it
is the pursuit of self-interest by informing humans about the positive and negative
consequences of their actions and choices in the life hereafter. As per Islam, the tendency
to seek worldly pleasures from certain goods and services is natural. The test is to
encourage ones conscience and fight these tendencies so that they do not grow beyond a
certain level. This test is for each person in individual capacity. We cannot completely
deny those tendencies. Neither Muhammad (peace be upon him) nor the pious caliphs
(rta) used any means other than moral persuasion to inculcate a parallel righteous
behavior alongside these natural tendencies so that they remain mere tendencies, i.e.
weak enough to not influence important choices humans make in matters involving a
moral issue. Islam inculcates piousness, kindness, cooperation and communal
responsibility in humans. In some instances, Islam guides explicitly to avoid
extravagance, lavishness and using certain products and services which harm a humans
ethical existence.
Religion provides the right balance between human objectives and their physical
limits and also promises salvage from the limitedness of this worldly life in heaven. This,
in turn, provides a permanent incentive to choose righteous behavior as an end with the
hope and fear of deterministic results in life hereafter.
Islam does not discourage seeking Allahs bounty in the temporal world. One prayer
in Quran reads as follows:
But of mankind there are some who say: Our Lord! Give us (Your
Bounties) in this world!
And for such there will be no portion in the Hereafter. And of them there are some
who say:
Our Lord! Give us in this world that which is good and in the
Hereafter that which is good, and save us from the torment of the
Fire! (Al-Baqarah: Verse 200-201)
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In economics terminology, Islam does not require us to completely abstain from

blessings of this world, but to have a balanced life and a balanced composition of the two
goods mentioned above. Afterlife accountability encourages observing ethical values and
Question of fairness and equity also recommends Ihsan can only be sufficiently dealt
with and incorporated into the preferences and behavior with belief in religion.

Environmental Issues & Economics

In a World Bank report, it was highlighted that the use of energy per capita in high
income countries is more than 5 times as much as in developing countries, and with only
15% of the worlds population, high income countries use more than half of its energy
(World development Indicators, 2006).
In Stern Review, it was highlighted that United States is found to be the most
polluting country in the world together with Europe which accounts for around 70% of
Worlds pollution.

Islam & Environmental Economics

With the concept of afterlife accountability, Islam immensely influences intertemporal
choice and behavior. It helps in private economic agents (consumers, producers etc.)
modifying their actions in such a way that takes the externalities into consideration and also
their own welfare, both in this world and afterwards. Afterlife accountability stimulate positive
change in behavior in a much more comprehensive and permanent manner than any regulation
or material incentive could possibly do.
Below, we mention several verses from Quran and sayings of Prophet Muhammad
(peace be upon Him) which discuss the responsibilities to the environment.
1) Prophet Muhammad (peace be upon Him) said:
I swear by Allah, one cannot become fully Muslim until he (or she) likes
for others whatever he (or she) likes for himself (or herself).
(Sahih al-Bukhari, Vol. 1, p. 14)
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2) Prophet Muhammad (peace be upon Him) said:

There is none better amongst the believers who plants a tree from which
a person, or an animal eats thereof. It is regarded as having given a
charitable gift for which there is great recompense.
(Narrated in Sahih Al-Bukhari, Vol 3: 513)
3) The Holy Quran says that:
He who does good of an atom's weight, he will see it. And he, who does
ill of an atom's weight, he will see it. (Az-Zilzaalaha: Verse 7-8)
4) Prophet Muhammad (peace be upon Him) said:
Whoever reclaims and cultivates dry, barren land, will be rewarded by
God for the act. So long as men and animals benefit from it, He will
record it as almsgiving.
Al-Munawi, Fayd al-Qadir,vi,39; Haythami, Majmaual-Zawaaid,iv, 67-8.
5) Prophet Muhammad (peace be upon Him) said:
On the day of Judgment, Allah will ask those who kill a sparrow
unfairly.
(Narrated in Muslim, Hadith No 57)
6) The Holy Quran says:
But waste not by excess: for Allah loveth not the wasters.
(Al-Anam: Verse 141)
When the Prophet Muhammad (peace be upon Him) saw Sad performing
wudu, He (peace be upon Him) said: What is this? You are wasting water.
Sad replied: Can there be wastefulness while performing ablution? The
Prophet Muhammad (peace be upon Him) replied: Yes even if you
perform it in a flowing river.

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(Narrated in Ibn-e-Maja)
7) In one verse, the Holy Quran says:
Say: Have you considered, if your water were one morning to have
seeped away, who then could bring you clear-flowing water?
(Al-Mulk: Verse 30)

Micro-Foundations of God-Conscious
Economic Agents in Islamic Economy
Salman Ahmed Shaikh (IBA Karachi)

Summary
Introduction
Purpose behind human existence is one of the basic questions in philosophy. Centuries
ago, pioneer philosophers used to study and discuss why we exist, but after renaissance
in Europe, social philosophers came to the front and raised issues of society and left study
of why we exist. Then, science developed, material life improved and economics
became just the study of material progress and how we can achieve it.
However, the world today represents plain realities about material progress. On one hand,
there are billions of people in abject poverty whereas; a small minority has majority
ownership over resources.
Islam as a comprehensive doctrine not only offers basis of such a social contract, but also
defines the purpose of human existence.
Mathematically,
Let us define Islamic ethics set be represented by IE and secular ethics set be
represented by SE. Then, we define following proposition:
IE SE
It means that IE is a superset of SE. We can also show it through a Venn diagram.

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Figure 1: Comparison of Islamic and Secular Ethics

Secular ethics is not absolute, rather it is relative. Unless it is organized, a secular society
has no reason or guiding mechanism to nurture the good virtues among human beings.
Hence, it is no surprise that famine, death from hunger and debt enslavement is the fact of
life for the three quarters of the people not because that overall, the societies have scarce
resources, but because the distribution of resources is inequitable.
In short we say that natural resources of world is use for those purposes by that these
would not utilizes properly and poor is now poorer and rich is now richer or richest.

Human Welfare Function in Islam

Sadeq (1987) explains that Islam emphasizes the achievement of human welfare which is
more comprehensive than economic welfare. Chapra (1999) also explains that while
economic development is indispensable, it is not sufficient to realize overall human
wellbeing by default.
In recent years, even the western concept of development has recognized the wider
dimensions of human development and the role of institutions (Mirakhor & Askari, 2010).
Hence, the human welfare function can be represented by:
Wh = f (Wt , mWe)
Where
Wh is total human welfare in both aspects of human life.
Wt is human welfare in worldly life.
We is human welfare in eternal life hereafter.
We can further explain this function to define W t and We. Both these functions are
defined as follows:
Wt = f (Zt)
Where Zt is a vector of variables which belong to the category of individual specific
positive utility gaining choices.
The constrained set which is a union of three sets is defined as follows:
CS = { Cworhip } U { Cself } U { Csociety } U { Cpeople }
Cworhip = {five times prayers, one month fasting, obligatory charity, hajj pilgrimage once}
Cself = {Acts which harm a persons own ethical and spiritual existence}
Csociety = {Acts which harm society and its institutions}
Cpeople = {Acts which harm other people, their rights, freedom or property}

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Hence, Islam does not deny individuals to fulfill their specific desires they can achieve in
career, marriage, family life, business, etc. It also does not deny temporary indebtedness
to achieve these things which can help smooth the intertemporal consumption in this
world.
We can define the eternal life welfare function as follows:
We = f (Ze)
Where Ze is a vector of variables which belong to the category of following Allahs
commands which will bring non-decreasing positive utility gain in life hereafter. These
commands do not segregate a humans life in two compartments. Rather, these commands
help the humans to live this worldly life in the best possible manner of obedience to Allah
and while being responsive and sensitive to the duties that they have to carry out in
different roles of life.
The achievement of lasting happiness and non-decreasing positive utility will only
happen through maximizing both the functions, especially the eternal life function.
For ensuring no corner solution, we shall have both Wt >0 and We >0.
The constraints of the life may sometimes require a tradeoff between the two functions.
In such instances, the trial is to choose the right path ordained by Allah so as to achieve
the maximum human welfare in the eternal life.
It is because of the parameter . Things that we enjoy in this world will be replaced by
similar things in afterlife, but they will provide much more utility and they will not be
finite nor will our satiation at any time will have binding constraints.

Income Function in Islamic Economy for Households

Income function of an individual I can be represented by:
Where, r is rent on physical asset holdings A. Market wage is w. Labor supply is Lt.
Lt is expected to be higher than in a capitalist economy as we show later. The reason is
that the feasible income sources in an Islamic economy will not allow a perpetual income
source which is a direct function of past accumulated wealth.
E(

) is income from direct and indirect participation in entrepreneurial activities for

individual I in time period t.

For an individual, E(

) can be functionally represented as:

Provided that 0 < pj 1.

Where
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pj is the profit sharing ratio in project j agreed for time period t at time period t-1.

is the profit in project j.

Following will be the welfare constraints on income sources.
a)Bribery (Al-Baqarah: 188).
b)Usurping others property (Al-Baqarah: 188).
c)Fraud (Al-Imran: 161).
d)Stealing and Robbery (Al-Maida: 38).
e)Income from sources of vulgarity (Al-Noor: 19).
f)Gambling (Al-Maida: 90).
g)Wine and through analogical deduction all such businesses (Al-Maida: 90).
h)Interest (Al-Baqarah: 275).

Consumption Function in Islamic economy

As per the human welfare function given above, the consumption function will be a part
of overall human welfare function.
It is an empirical observation that people desire to have smooth consumption through
their lifetimes. Lifecycle income hypothesis by Modigilani & Brumberg (1954) and
permanent income hypothesis by Friedman (1957) try to explain that. Both negate the
Keynes (1936) assertion that average propensity to consume (APC) falls as income rises.
Microeconomic evidence is also consistent with lifecycle income hypothesis in various
empirical studies in the literature.
Differences in risk preference and risk tolerance can also be incorporated with effective
equity based financial intermediation or by seeking non-entrepreneurial income sources
like providing labor or capital for fixed wage and rent respectively.
Functional representation of this discussion can make use of the following functional
forms:
1. Leontief Perfect Compliments
2. Second Party Preferences
3. Family or Relational Utility
4. Lexicographic Utility
Family system of Islam brings social capital into existence. It ensures empathy and
responsibility. It brings a very lasting and durable social safety net. Islamic injunctions
about how to treat orphans ensure social security for individuals with special
circumstances. Furthermore, the inheritance laws ensure that the wealth of the deceased is
distributed widely among the members of the family of the deceased and this
permanently and systematically ensures doing away with the concentration of wealth in
every generation.

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Welfare Constraints on Consumption

Following will be the welfare constraints on consumption function.
Limit on Choice Set

Islam discourages lavish consumption, i.e. Israaf (extravagance even in lawful things)
and Tabzeer (consumption in unlawful things like liquor, free sex etc). Islam encourages
modesty and balance. Islam encourages spending on society with directives for charity.
Allah promises great rewards for charity.
Limit on Budget Constraint

Islamic principles discourage indebtedness unless it is necessary . That is why;

provision of a loan is a non-compensatory act in Islam. However, for consumption
smoothening motive, the consumer could borrow if needed.

Labor Market Equilibrium in Islamic Economy

Producer Behavior in Islamic Economy

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Amin et al (2003) explained that in the Islamic framework, it is assumed that economic
agents are guided by Islamic values. Thus, an Islamic producer, being accountable to
Allah, treats the resources at his command as a trust and the production of goods as a
duty, and he will base his production decisions on the concept of maslaha.
The author opines that a producer in an Islamic market could still be profit-driven; but,
being governed by the Islamic principles, the producers valuation of economic costs will
be modified. Hence, the producer will internalize the externalities in its utility and cost
functions.
Hence, it could be appreciated that several authors have emphasized on the ethical and
spiritual rationality in the firms behavior. In a value neutral framework, there is no cap
or mechanism to solve problem of a humans greed. In fact, a value neutral framework
provides a cover to follow, pursue, harness and practice greed. On the other hand, Islam
addresses hearts and first of all, it purifies the heart, encourages compassion,
responsibility and gives concepts of shared responsibility and afterlife accountability.
Mainstream economics define physical capital stock as things that are produced means
of production. In a market economy, physical capital stocks are either traded or rented.
But when it comes to the price of capital, the user cost of capital is used given by
Jorgenson (1963).
UC = Pk (r + d)
UC is user cost of capital,
Pk is purchase price of capital stock, r is real rate of interest,
d is the depreciation rate.
In the intertemporal transfer of money in the loanable funds market, interest is legally
regarded as the price of capital. However, it does not answer the philosophical and deep
question of Thomas Aquinas as to what is the right price of money.
From the economic standpoint, there are following problems in interest based financial
intermediation and its subsequent effects on goods markets and resource markets.
i)It ignores the negative externality imposed through inflation on people. Interest paid is
added in cost and through transfer pricing, it is paid by people eventually.
ii)It discourages investment in socially optimal profitable projects, but which are not
favored because of relative costing comparison from prevalent real interest rate.
iii)It compels firms to engage in aggressive advertising and to promote consumerism to
meet interest cost. Selling small number of units will not allow benefit from leveraging
and meeting interest cost. Hence, they have no choice than to promote as much sales as
possible.
iv)If sales do not increase, it may lead to business cycle fluctuations with unplanned
increase in inventories.
v)With increased pressure to service debt, the environmental degradation and human
resource exploitation may become common.
vi)It results in skewed distribution of income and wealth with guaranteed return to
capitalists and uncertain return to real sector entrepreneurs who are burdened to provide
incessant increase to capitalists.
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vii)It supports only the wealthy entrepreneurs who are able to afford interest payments
right from the start from their entrepreneurial pursuits and who already own capital that
can be used as collateral. This will affect the kinds of entrepreneurial investments they
make and hence allocation of resources.
viii)With barriers to entry due to restricted availability of funds for investment in real
sector, the real sector could result in increased market concentration in large scale
businesses.
ix)It may result in other negative externalities, e.g. increased income inequality, poverty
and below full employment use of real scarce resources resulting by artificially making
capital scarce. This is discussed by Keynes (1936) in his seminal book.
x)Increased printing of fiat money by borrowing on interest will jeopardize the welfare of
future generations. With no afterlife accountability, no policy maker or institution can
incorporate infinite horizon and accountability to future generations. This will create the
problem of moral hazard.
Modigliani & Miller (1963) argued that value of a levered firm is greater than the value
of an unlevered firm. The difference in value comes from the tax benefit accruing to a
levered firm. But, they ignored the bankruptcy costs and the case where even if a
company is solvent, the economy may go through a recession.
Furthermore, if this tax benefit is provided to an unleveled firm by making dividends to
be tax deductible; then, value of a levered firm may cease to have any extra value greater
than an unlevered firm.

Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Table 2: Wealth Concentration A Simulation Example

A
B
Wealth
Interest
Period
Wealth
1,000,000
0
1,000,000
1,100,000
100,000
1
975,000
1,210,000
110,000
2
950,625
1,331,000
121,000
3
926,859
1,464,100
133,100
4
903,688
1,610,510
146,410
5
881,096
1,771,561
161,051
6
859,068
1,948,717
177,156
7
837,592
2,143,589
194,872
8
816,652
2,357,948
214,359
9
796,236
2,593,742
235,795
10
776,330
2,853,117
259,374
11
756,921
3,138,428
285,312
12
737,998
3,452,271
313,843
13
719,548
3,797,498
345,227
14
701,560
4,177,248
379,750
15
684,021

Zakat
25,000
24,375
23,766
23,171
22,592
22,027
21,477
20,940
20,416
19,906
19,408
18,923
18,450
17,989
17,539
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16
17
18
19
20

4,594,973
5,054,470
5,559,917
6,115,909
6,727,500

417,725
459,497
505,447
555,992
611,591

16
17
18
19
20

666,920
650,247
633,991
618,141
602,688

17,101
16,673
16,256
15,850
15,454

Conclusion
In this paper, we discussed the distinct nature of the concept of human welfare in Islam.
We discussed how Islamic worldview and beliefs solve the problem of greed and
encourage ethical behavior in absolute sense. We presented how Islamic principles can
systematically help to achieve equitable distribution of resources within a market system.
We discussed the institution of Zakat and how it will incorporate diminishing marginal
utility of wealth and also achieve the objective of circulation of wealth and utilization of
idle resources. We also presented labor market dynamics and equilibrium in an Islamic
economy. We showed how labor force participation, human capital development and
technical progress will be achieved in an Islamic economy. Our analysis suggests that the
Islamic principles can foster competition, efficiency, investment and employment without
compromising on equity.

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