Articles on Islamic Economics

Circular Flow Model: Islamic Economics Perspective

Salman Ahmed Shaikh

As per Islamic principles, within certain bounds, the market forces can operate and will determine which goods should be produced and offered at what price. Through private sector investment and production, resource markets and product markets will function to enable households to obtain purchasing power by providing factors of production like labor or land in the production process and earn compensation in terms of wage and rent, respectively.

The major difference from capitalistic system is that rather than having a fixed compensation, the capital will only earn a share in actual profit/loss out of the production process in which it is used. Firms will use the factors of production to produce goods and services and households will be able to pay for these goods and services using the purchasing power they obtain by providing factors of production in the production process to the firms. Hence, most human needs would be fulfilled through independent choices of households and firms interacting in the market.

However, this circular flow is distinct from a completely capitalistic economy in certain ways. These are explained as follows:

1)   There is no fixed compensation to capital. Hence, the capital has to be used in some production process to earn its reward out of actual net payoffs arising from a production process. This will have positive effects on distribution of income as well as wealth.

2)   With no fixed compensation to capital and together with a tax on idle capital, the capital would be directed towards production activities enabling the households to get more employment opportunities rather than to rely on subsidies and poverty reduction grants.

3)   There will be lesser burden on fiscal exchequer to spend on debt servicing and subsidies.

4)   More resources will be freed for spending on development.

5)   Redistribution of resources will always be progressive in nature i.e. wealth will flow from the rich to the poor. Moreover, any capitalist would only earn profits in a competitive economy after taking part in the production process rather than just loaning out money and earn interest on it.

6)   Competitive nature of the economy which is not more than an assumption in a capitalistic system would be fostered through banning fixed return on capital and introducing direct tax on idle capital along with lenient tax on productive income and reduced average cost of capital by disallowing interest.

7)   With an opportunity to share in profits, households will have an added benefit to not only gain purchasing power through provision of labor and land, but also through provision of capital. Thus, they can share in actual profits rather than earn just a fixed rate of interest which is negative in real terms in most developing countries.

8)   Since capital will not have fixed interest as compensation, the compensation to each factor would be linked with payoffs from the production process.

9)   Capital use in productive activities would increase rather than remaining idle and out of production process. Unlike in a capitalistic system, capital will not add a burden factor, i.e. interest cost in the production process. It will get compensation from the actual profits earned rather than adding to the cost of productive activities.

10)   Through the above features, efficiency as well as equity can both be adequately addressed and obtained without having to rely on force, exorbitant taxes, and unnecessary government intervention.

6 replies »

    • It will provide relief to those in need through wealth and income redistribution by using Islamic levies, such as Zakat (Levy on surplus wealth) and Ushr (Levy on production). Besides that, maintaining law and order and providing social security and enabling environment.


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