Articles on Islamic Economics

Production Function in an Islamic Economic Framework

Salman Ahmed Shaikh

Production function in economics explains the functional relationship between inputs and output. Whatever mathematical form the production function takes, the basic ingredients of any production function are inputs and how they relate with output. The most commonly taken inputs are Labor (N) and Capital (K). Total Factor Productivity (TFP) is the summary measure of the impacts of other inputs, social and legal infrastructure and the technological change. Below, we summarize the impact of Islamic economic principles on the production function in an economy.

Factors of Increase in Capital

–         Ban on interest increases investible capital

In an Islamic economic framework, tax on cash and capital at 2.5% will force the people to invest their money capital in productive uses. With prohibition of interest, households will use the money capital in their own business or invest with equity participation in Mudarabah and stocks.

–         Zakat indirectly increases investible capital

In an Islamic economic framework, with a lenient rate of income Zakat, i.e. Khamsa (5%) and Ushr (10%), the productive sector is provided with incentive to ensure achieving potential output with lenient fiscal levies and circulation of capital through prohibition of interest. This could bring about increase in output per person in an economy and could bring stability in prices.

Besides this, a consistent and credible low Zakat rate policy with broader Zakat base would ensure: 1) minimum distortions, 2) boost aggregate demand and 3) encourage investment by decreasing costs of doing business. This could also simultaneously solve microeconomic problems of imperfection in markets by increasing competition and helping to reduce market power.

–         Dis-allowance of risk free money fosters the entrepreneurial culture

Money itself has no intrinsic value and is neither a rentable asset nor a tradable commodity as per Islamic principles. If capital is combined with labor, it “could” produce profit, but if money alone is lent, the stipulated interest it earns is not permissible as per Islamic principles. In Islamic economic framework, interest is neither a justifiable reward of money nor capital. Money holder/owner has to convert it in one of the other factors of production, namely 1) land with natural resource, 2) physical capital stock and 3) or become an investing entrepreneur to have any justifiable compensation out of the production process.

Factors of Increase in Labor Supply

–         Encouragement to be self-dependent

Islam encourages people to avoid indebtedness and dependency. A Hadith says:

“The upper hand is better than the lower hand, and the upper hand is the one that spends, and the lower hand is the one that asks.” 

(Sunan Abu Daud, Vol 2, Book of Zakāt, Hadith Number 1648).

–         Increase in investible capital increases employment level

In an Islamic economic framework, if people would not invest, their wealth would shrink and distributed among poor masses of the society through Zakat. If they want to avoid erosion in wealth, they are urged to either enter in productive activities themselves or invest in such ventures indirectly with their capital contribution. This will increase productive investment in the economy, bring more employment opportunities and make markets more competitive.

Factors of Increase in Total Factor Productivity

With higher levels of investment, circulation of wealth and competitive markets, innovation and quality enhancement will be the only means of sustaining the edge for firms in an Islamic economic framework. Hence, there will be more focus on innovation, customer satisfaction and hence speed of innovation and productivity is expected to increase. The supply side of innovation, which is the human capital, will also be incentivized through employment creation as a result of removing concentration and idleness of wealth.

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