Articles on Islamic Finance

Opportunity Cost of Capital in Islamic Economic Framework

Salman Ahmed Shaikh

Opportunity cost is a useful concept in economics. Below, we try to explain how this concept is used to justify interest by some contemporary scholars.

If I have a job paying me $1,000 a month and I decide to leave it and complete my PhD for two years. Then, the opportunity cost of going to do PhD is $24,000 of job income forgone. When I am considering the option of doing PhD, I must also bear in mind this implicit opportunity cost along with fees and cost of books (out of pocket costs).

Opportunity cost of an activity is the cost of the best alternative forgone. For example, if I had another job option paying me $500 a month, then, the opportunity cost will remain to be $24,000. It is because by not doing PhD, I would have taken one of the two jobs and I will have taken the one that pays me $1,000 a month over the one that pays me $500 a month, all else equal. Then, the opportunity cost of going to PhD is $24,000 of job (best alternative of the two jobs) income forgone plus the fees and cost of books (out of pocket costs).

Just like I cannot ask or force the university to pay me $1,000 each month for me to do PhD, the owner of capital cannot ask or force the borrower to pay him/her any stipulated increase over the principal amount in a loan transaction in Islamic jurisprudence.

Time Value of Money & Islamic Finance

In investment for trade (which Islam allows), the investment goes through the entire process of a commercial activity that involves risk taking at each stage and any compensation on investment is strictly dependent upon the outcome of the commercial activity. The profit for the businessperson strictly depends upon the actual profit realized after taking entrepreneurial risk. It does not depend upon time.

Time value of money is the basis of interest. Time value of money is the problem for the investor to avoid keeping his/her money idle and to avoid forgoing the use of money that may bring positive value to his/her investment. However, it does not mean that the lender can demand an arbitrary increase as the cost of using money.

2 replies »

    • Opportunity cost can be used to make economic decisions. For instance, producing wheat rather than corn if one is more efficient in making wheat over corn. However, in advancement of money as investment, Islam guides that if we want to earn return on investment, we shall take risk of productive enterprise by i) Investing in asset/commodities and reselling or providing usage of rentable assets for rent while bearing the risk of asset ownership, ii) Investing in economic enterprise by organizing factors of production to produce a good/service and sell it to earn profit, and iii) Investing indirectly in i) and ii) through financial intermediation by investing with Islamic banks, Islamic mutual funds and capital market intermediation by investing in Sukuk and Halal stocks, for instance. Opportunity cost does not become someone else’s liability even if it exists. It is a person’s private cost. One can manage it through different ways. In order to earn returns, Islam has provided trade, lease and equity investment in a business undertaking as possible solutions. This framework has positive effects on economy from the perspective of employment, investment and production.


Questions, Feedback or Comments

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.