Defining Microeconomics

Microeconomics is focused on how consumers and producers (businesses) make choices. It attempts to study human behavior by using a “scientific” approach. For economic actors to make a choice, it means that a selection was made among alternatives, and this involves two ideas central to conventional economics: scarcity and opportunity cost.

On one hand, resources are limited. There is only so much oil, land, and people available at any one time, and it is because of this that resources are not free and command a price. On the other hand, according to neoclassical microeconomics, human wants and desires for goods and services are unlimited. We always want more national security, food, and healthcare. Had our resources been infinite, we would not have to make choices. We would simply say yes to all of our wants and desires. However, economic actors must make choices to cope with scarcity. It is the constraint of scarcity that makes us choose among alternatives. This is the basis of conventional microeconomics.

The choices we face as a result of scarcity result in three fundamental economic questions that all economies must answer:

1. What should be produced? Using a nation's scarce resources to produce a good requires giving up producing another. Should the wilderness area be preserved as a national park or used for factories? Should farmers produce agricultural goods or livestock, and which goods and which livestock?
2. How should goods and services be produced? There are many different ways (technologies and combinations of factor inputs) to produce goods and services. Should the goods be produced locally or in foreign plants?
3. For whom should goods and services be produced? Along with the production of the goods comes the question of to whom the goods should go. Should food produced be sold to the highest bidder, or should poorer people have the chance to purchase these goods?

These questions are faced by all economies every day and are considered to be the three broad microeconomic questions.

Given the constraint of scarcity, it is necessary to define opportunity cost: the value of the next best alternative in making a choice. Opportunity cost should not be confused with the purchase price of the item chosen. Consider the cost of attending postsecondary education. School fees, living expenses, and books are all a part of that cost. However, the most important cost is the value of forgone alternative uses of the time spent at postsecondary school. Students could have worked, volunteered, or practiced a hobby instead of attending postsecondary school. Economists argue that understanding opportunity cost is crucial to studying individual choices. Assuming that we always choose the most beneficial option among the available set, the expected benefits of the alternatives affect our decision. As the alternatives change, choices individuals make also change. A sunny day can change the opportunity cost of going for a run. We can expect highly paid individuals to work long hours, as a high income changes the trade-off between work and play, which is opportunity cost of taking time off.

The concepts of scarcity and opportunity cost are central to the study of how economic actors make choices. Scarcity forces us to make choices among alternatives, and the opportunity cost of our choice is the next best forgone alternative. An economy cannot produce an unlimited quantity of goods and services; it has to decide what goods to produce and how best to use its resources of labor, land, other natural resources, capital, and technology to produce these goods. Figure 5.1 broadly shows the trade-offs involved in what is called a production possibility frontier. The curved frontier represents the trade-off between producing good 1 and good 2; the frontier is curved because of diminishing returns in production. Points A and B on the smaller frontier represent efficient and full employment of available resources, whereas point D is a production level denoting lots of unemployed resources (excess capacity) and/or inefficient (such as technology) production practices. The economy cannot produce outside (in excess) of this frontier, but over time, with investment, education, and technical progress, the production possibilities could expand to a new and larger frontier that includes a level of output such as point C.

The three basic assumptions of conventional microeconomics include:

1. Individual economic actors make choices that create a maximum value of some objective, given the constraints they face. Consumers' objective is their own satisfaction, and they make choices (in reality very difficult calculations) in pursuit of maximizing their own satisfaction; in economics jargon, this is maximizing “utility.” The objective of business firms is to maximize profits.
2. Individuals maximize by making choices “at the margin,” and maximization occurs when the marginal benefit equals the marginal cost. At this point, the net benefit of an activity is maximized.
3. Individuals behave rationally. This means that individuals indeed act in their own interest as if they are making decisions that will maximize their utility.

These assumptions are fundamental to the way conventional economists approach microeconomics and will help frame concepts later in this chapter.

Issue of Needs Versus Wants

The conventional assumption is that individuals behave rationally and maximize some objective, given their constraints. Neoclassical economists assume that the economic objective of individual consumers is to satisfy their unlimited needs and wants. Economists are careful to distinguish between needs and wants. Humans need shelter; however, they do not need mansions. A mansion is a want. Economists emphasize that once humans have achieved the bare subsistence level of consumption of food, shelter, and clothing required to live, they can abandon all reference to needs and speak only in terms of wants. With our boundless appetites for things, we are challenged to fulfill our desires to the maximum, given the constraints we face, primarily our budgets. The problem we face is this: How do we go about allocating our income among the available goods and services?

When it comes to defining needs in Islam, the Prophet (sawa) explained in a hadeeth, or saying, what constitutes “subsistence level,” which is considered a right of all humans and includes the right to bread, water, clothing, and shelter. The Prophet (sawa) also mentioned a “sufficiency level,” which includes the financial ability to marry and to have suitable housing and a means for transportation.⁶

In the mind of an economic human who is rasheed (i.e., a rational Muslim consumer who is making progress on the path to perfection, and as a result applies sound judgment in line with the maqasid-al-Shariah [the goal of Shariah]), the needs of others are considered more important than the wants of the individual himself. This is in line with the teachings of the Prophet Mohammad (sawa), who would partake in public borrowing to feed those whose subsistence level was not being met by society.⁷ Such unselfishness shows the importance of meeting the need fulfillment of all humanity as one of the biggest economic goals in Islam. It is important to note that human needs, according to a hadeeth, are not equal for everyone. Part of rushd (individual self-development) is to know what personal needs are and to act accordingly.⁸ It is important to note that Allah (swt) does not prohibit the betterment of life in terms of the material (Quran 7:32). However, He dislikes opulent, extravagant, and wasteful behavior. Allah (swt) addresses all of humanity in a verse of the Quran (7:31) that says:

O Children of Adam! Wear your beautiful apparel at every time and place of prayer: Eat and Drink: but waste not by excess, for Allah loves not the wasters.

From the Quran and the example of the Prophet (sawa), economic needs have been defined, both in an absolute and a relative manner. In light of the teachings of the Prophet (sawa) and the maqasid, after one has satisfied both his “subsistence” and “sufficiency” levels, then the individual must seek to allocate a portion of his budget to those in need.

Given the concept of scarcity, an important question is whether resources are scarce relative to needs. This is referred to as “relative scarcity,” meaning that the means of satisfaction (i.e., goods and services) are scarce in relation to people's needs at a point in time. Essentially, it means that though there may be sufficient physical quantities of the resources (or goods and services produced), scarcity exists because of problems in the distribution of available goods and services. This is different from “absolute scarcity,” which means there are simply insufficient quantities of a resource to produce the required goods and services.

Some scholars, such as Masri, do not agree with the premise that in the context of Islamic economics, there can be no scarcity of resources relative to needs. He argues that scarcity will remain, and, as a result, the economic problem of how to meet unlimited wants with limited resources will remain in the Islamic economic system.⁹ Others argue that the concept of relative scarcity cannot be rejected from an Islamic perspective and that, in fact, the logic behind the concept has been indicated in the Quran (15:19–21). The point concerning relative scarcity from a Quranic perspective is that the stock of natural resources have been created in abundance to meet the needs of humanity; however, the distribution of these resources is not abundant by Allah's (swt) will. This is His wisdom.¹⁰ This position is based on the belief that the Almighty created the world with sufficient resources to fulfill the needs of all humans as long as humans learned to share. In a sense, the Almighty created a world in which at the macro or global level, there was no scarcity to satisfy human needs. This is true even at the micro or local level as long as humans worked hard and shared with the less fortunate. The Almighty also did not create humans with equal abilities; He created the world and humans in this way as a test for humans on this plane of existence. Furthermore, as we explain later, while conventional economics takes unlimited human wants and the desire for opulence as a given, Islam preaches the need for humans to suppress their wants, avoid opulence, and share (a moral activity that brings its own rewards and happiness).

Consumer Behavior

Francis Edgeworth, one of the earliest and most important contributors to the theory of conventional consumer behavior, imagined a device called a hedonimeter (from the word “hedonism”) that measures pleasure:

Let there be granted to the science of pleasure what is granted to the science of energy; to imagine an ideally perfect instrument, a psychophysical machine, continually registering the height of pleasure experienced by an individual, exactly according to the verdict of consciousness, or rather diverging therefrom according to a law of errors. From moment to moment the hedonimeter varies; the delicate index now flickering with the flutter of the passions, now steadied by intellectual activity, now sunk whole hours in the neighborhood of zero, or momentarily springing up towards infinity.¹¹

The motivation behind consumer behavior according to neoclassical economics is satisfaction, or what economists call utility. The concept of utility cannot be measured on its own in the abstract. A person who consumes a good gains utility from it; however, this utility cannot be measured on its own. Utility is defined as an ordinal measurement, not a cardinal one. Thus, utility gained from a good can be ranked vis-à-vis an alternative good. For example, an environmentalist likely derives more utility from a low-carbon-emissions vehicle than a large gas-guzzling truck.

In the pursuit of utility, conventional economics assumes consumers act as if they can measure utility and make decisions such that their utility is as high as possible. As such, the total utility is the number of units of utility that a consumer gains from consuming a given quantity of a good, service, or activity during a particular time period. Upon reflection, it is hard to imagine that there is even a single human who constantly makes economic decisions in this way, let alone that all humans do so. Total utility rises with an additional unit of the good, service, or activity, and ceteris paribus, the last unit of utility is called the marginal utility. An important law, evident in most dimensions of life, is the law of diminishing returns. The utility derived from the first slice of pizza consumed would be significant. However, with each additional pizza slice consumed, the marginal utility decreases (as you are becoming full, the utility derived from the last slice of pizza becomes less and less). An important assertion is that the marginal utility approaches zero as consumption of the good approaches infinity; however, marginal utility never really is zero. According to mainstream economics, in the pursuit of satisfying our unlimited wants and desires, when offered a free pizza after having consumed a dozen, we will accept it, as the marginal utility is still positive. Or more realistically, we will still consume other goods even though we are full.

To understand how consumers maximize utility, we introduce the marginal benefit rule. First, it is important to realize consumers have budget constraints. To simplify the analysis, economists often assume that consumers do not save or borrow. Their available budget is simply their income. Given that consumers are expected to spend their budget, we can expect consumers to spend their budget in a way that maximizes utility. This is done through the marginal benefit rule, which states that a good would be consumed as long the marginal benefit of its consumption exceeds the marginal cost. The marginal benefit of the good or activity is the utility gained by spending an additional $1 on the good. The marginal cost is the utility lost by spending $1 less on another good. They are both calculated by taking the marginal utility (MU) and dividing by its price (P):

(5.1)

Let's consider two goods, good X and Y. The marginal utility of good X is 10, and its price is $5. This means that an extra $1 spent on good X buys 2 units of utility. Good Y has a marginal utility of 5; however, it also costs $5. This means that an extra $1 spent on good Y buys 1 unit of utility. The decision between spending the next dollar on good X or Y is made simple by seeing which good will buy more utility per dollar spent, or marginal benefit:

(5.2)

In this case, it is clear the consumer would buy good X. However, as the consumer buys more of good X relative to good Y, the marginal utilities of the goods will change due to the law of diminishing marginal returns. The marginal utility of good X will decline relative to that of good Y as the consumer purchases more of good X. As consumption increases, according to the marginal decision rule, the value of the left- and right-hand sides of the equation will approach equality. When both sides are equal, total utility has been maximized:

(5.3)

This result can be extended to all goods, services, and activities consumed:

(5.4)

Equation 5.4 is a simple expression of the rational spending rule, which solves the problem of allocating a fixed budget across different goods while maximizing utility. In conventional economics, utility is all that matters and there is no room for value judgments. This utility maximization reflects rational behavior in conventional consumer theory. Interestingly, the words “utility” and “rational” have linguistic meanings that are different from their economic concepts. The concept of utility is developed as “good morality” as perceived by the individual. What constitutes “good” is not universal but is relative to what the individual thinks in achieving self-interest. These definitions and concepts do not conform to Islamic values.

Though Islamic economists should be interested in studying the actual behavior of consumers, it is also important to study and define the behavior of an idealized Muslim consumer. To do so, the correct approach would be to transform some relevant Shariah principles and guidelines into axioms. For starters, certain materials and business dealings prohibited by Shariah must be excluded from the consumer's feasible set of commodities and transactions, such as alcohol and interest. Some other matters are less clear and have to be treated on the basis of ijtihad (independent reasoning). For example, a rasheed must not be either opulent or a miser, as the Almighty says in the Quran (25:67):

Those who, when they spend, are not extravagant and not niggardly, but hold a just balance between those (extremes).

Unlike conventional economics, where rational consumers allocate their budgets across goods such that utility is maximized, Islam challenges and encourages humans to maintain a just balance between extremes and to control their wants. The budget of a Muslim consumer is subject to taxes, such as zakat (the practice of charitable alms giving based on accumulated wealth), kharaj (tax on land), and khums (the obligation to give one-fifth of certain types of income to charity). Even after all these taxes are paid, the income of a Muslim does not determine consumption, as it must be shared further if income disparities and poverty continue. Regardless of whether resources are absolutely scarce, the safest route is to not consume beyond one's needs, as the welfare of others in society and those of future generations matters. The differences in assumed consumer behaviors in the conventional and the Islamic systems are distinct (see Box 5.1).

Theory of the Firm

Firms are important entities that bring together factors of production to produce goods and services that are demanded by consumers. In a market economy, the firm's role is significant and remarkable: Besides managing and combining factors of production efficiently, a firm also plays an important role in enhancing the market mechanism. According to conventional economics, like consumers, firms also use the marginal decision rule. However, conventional economists assume firms function in order to earn profits, which they try to maximize. Given this assumption, economists can predict how firms will behave in response to changes in demand, factor input prices, and other changing conditions. For example, it was no surprise to economists that firms moved some of their operations overseas as the cost of labor rose in the United States relative to that abroad. A question remains: How do firms go about maximizing profits?

Total revenue is simply the price per unit of a good multiplied by the quantity of the good sold. Marginal revenue is the revenue received for the last good sold, and in the case of a perfectly competitive market, the marginal revenue is simply the price of the good; that is, the cost of producing the last unit of a good determines its unit price. Marginal cost is the cost of making an additional unit of the good. To maximize profits, the quantity produced by a firm should be such that the marginal revenue equals the marginal cost. In a perfectly competitive market, this means that marginal revenue and marginal cost equal the price of the good. This is consistent with the maximizing condition observed with consumers: To maximize the objective function, the marginal benefit rule is used to make the decision to expand an activity until the marginal benefit, in this case marginal revenue, equals the marginal cost. To produce more than this, the increase in revenue would be less than the increase in cost, thus reducing profits. This is what economists mean by making decisions at the margin.

Production Cost

Two periods are invariably identified in production analysis: the short run and the long run. Let's first consider the short run: that is a planning period where at least one factor of production is a fixed, or does not vary. For example, for a factory, the building is a fixed factor of production for at least a year. This limits the firm's range of choices among its factors of production. A factor of production whose quantity can be changed during a period is called a variable factor of production. An example in the case of the factory would be labor, which can be increased and decreased anytime. As the firm expands the use of a factor of production (while holding all other factors of production as fixed), it will experience increasing, then diminishing, then negative marginal returns. For example, consider a hypothetical firm called BestShoes. Let's assume its fixed factor of production is its capital equipment, and its only variable factor of production is labor. As the units of labor per day are increased, the total number of shoes produced will increase. However, according to the law of diminishing marginal returns, the marginal return from each additional unit of labor decreases until it eventually becomes negative.

A firm's production costs in the short run are dependent on the quantity produced and the prices of its factors of production. The production costs are composed of fixed costs, the costs associated with the fixed factors of production, and variable costs, which are the variable factors of production. Total variable costs vary with the level of output, while total fixed costs do not vary with output. The total cost (TC) is the sum of total variable costs (TVC) and total fixed costs (TFC).

(5.5)

From a total cost curve, marginal cost, the total cost of making an additional unit, can be found simply by deriving the total cost curve.

The long run is a planning period over which a firm can consider changing the quantity of all of its factors of production. To maximize profits in the long run, firms must select the combination of factors of production for their chosen level of output that minimizes costs. To determine the cost minimizing factor mix, the marginal decision rule will again be used. Let's consider the marginal benefit of an additional dollar spent on a factor of production. Of course, the benefit in this case is not utility, as was the case with consumers, but product output. The marginal product (MP) per dollar spent on a factor of production (P), or the marginal product factor price, is simply calculated as shown in equation 5.6:

(5.6)

Similar to the outcome of maximizing consumer utility, to choose the combination of factors (n) that will maximize profits, the firm must seek a combination of factors wherein the marginal product price to factor price is equal:

(5.7)

Equation 5.7 is the same outcome of utility maximization. A simple and intuitive explanation of this equation at work is in the case of labor cost increases, the firm will shift to a factor mix that uses relatively less labor and more capital.

As shown earlier, there are parallels between consumer utility maximization and firm profit maximization. Aside from the mathematical similarities, another similarity is that neither firm nor consumer behavior makes room for value judgments. The theoretical model of the firm is generally based on purely economic variables. The construction of the objective function primarily emanates from the maximization of profit and minimization of cost.¹² Seldom does the objective function include social, ethical, and moral components. Opportunity cost is a pure economic phenomenon and does not include moral or social dimensions. In Islam, this is not the case.

Early Muslim scholars discussed the behavior of firms and their responsibilities toward society and the community. The Islamic system of governance works on the principle of no injury (the principle of maslahah).¹³ It is established that worldly goods ultimately belong to Allah (swt) and are for the advantage of all. No one has the right to use these goods to cause a loss to the other members of society. According to Islamic economists, it is the moral and social responsibility of the firm to care for all stakeholders while it earns a profit. The main objective of the Muslim entrepreneur is to promote justice: to earn a reasonable profit, charge a just price, pay just wages, and enhance the welfare of society. In other words, Islam calls for socially responsible businesses. In many ways, Islam expects firms to behave in a similar manner to consumers when it comes to using rushd to make sound judgments for society.

Islamic economists debate whether conventional firm behavior and profit maximization is a useful and allowable theoretical construct in Islamic economics. The general answer, due to reasons such as the predictive power of firm behavior theory, is yes. However, Islamic economists argue that some modifications are needed. In particular, the profit maximization postulate of conventional economics has been touted for the applicability of conventional economic theory in Islamic economics. Thus far, two views have emerged. The first view holds that the profit maximization postulate is a useful theoretical construct but has to be modified before it is applicable to a firm operating in an Islamic system. An example of this view was articulated by Metwally, who first modified the profit maximization objective by introducing “charity” as an additional element in the objective function.¹⁴

The second view, which will be the focus of our discussion, has two components. First, it argues that an Islamic economy operates on the basis of rules, derived from the Quran and Sunnah, which constitute its institutional and normative structure.¹⁵ Once these rules are in place, positive theories of firm behavior, among other theoretical constructs, can yield valuable insights as guides to policy. Second, this view argues that the profit maximization postulate is an efficiency criterion, and, as such, it is applicable to an Islamic economy, provided that the normative structure represented by the institutional framework, derived from the Quran and Sunnah, is in place.¹⁶ This view has gained traction as Islamic economists over the past few decades have argued: “We cannot tame markets with the cane of legislation. Hence, firms cannot be forced to act morally in such a market. We need to transform the market into an ethicized market by means of endogenizing the moral elements in all socioeconomic menus, preferences, institutions and interactions.”¹⁷ In other words, if the institutional structure is in place and the rules are internalized, positive theory can and will serve useful purposes.

Hasan argues that while the profit maximization postulate has been heavily criticized even in conventional economics, it continues to survive because, without it, the process of price formation in different markets and under different conditions would be difficult to explain, and because no other theoretical construct having the same degree of explanatory and predictive power has been offered as its replacement.¹⁸ Hasan asserts that theoretical constructs such as profit maximization “constitute minimal tools needed to explain and investigate economic phenomena to help formulate theories with predictive ability needed to guide economic policy.”¹⁹

Dynamics of Demand and Supply

Demand captures a consumer's desire and ability to pay a price for a good or service. The demand for a good or service is made up of the demand of each individual consumer who made the choice to consume the good or service as part of maximizing its utility. All goods and services have their own special attributes that determine people's willingness and ability to consume. For example, when estimating how many tons of rice people will buy this year, there are many variables to consider. One major variable is price.

Before introducing the relationship between price and demand, it helps to state up front the law of demand: The law of demand holds that, for goods and services, a higher price leads to a reduction in the quantity demanded while a lower price leads to an increase in the quantity demanded.

The quantity demanded of a good or service is the quantity buyers are able and willing to buy at a particular price during a particular period, ceteris paribus. The law of demand is considered a law because of the results of countless studies that support it. A change in price causes a movement along the demand curve, which is a change in quantity demanded due to change in price. Figure 5.2 is a demand curve along with its demand schedule to illustrate the relationship between demand and price. Demand curves represent the total demand for a good or service.

When dealing with the relationship between price and demand, it is important to assume all else—especially income and the price of complementary and competitive goods—remained unchanged. However, in reality, price is not the only variable that determines the quantity of a good or service demanded. Other independent variables that are determinants of demand are income, consumer preferences, price of complementary and competitive goods and services, and buyer expectations. For example, as income rises, a person's consumption of many goods and services increases, thus increasing the quantity demanded. Changes in preferences can increase or decrease the demand of goods and services. Changes in prices of related goods and services (substitutes) can drive consumers toward or away from particular goods and services. Demographic changes, such as a declining birth rate, can decrease the demand for tutors and school supplies. If buyers expect the price of corn to increase in the future, the demand for corn in the current period would increase. When a change in one of these variables (such as income) increases demand, the demand curve shifts to the right, and vice versa.

Supply is the amount of a good that producers are willing to produce and sell at a particular price at a given time. The total supply of a good or service is the sum of the outputs of individual businesses that used the marginal decision rule to produce the good or service to maximize profits. What determines the quantity of goods or services firms are willing to produce? As was the case with demand, price is an important factor. In general, when there are many sellers, an increase in price results in an increase in quantity supplied, ceteris paribus. Though there are exceptions to this rule, this is often referred to as the law of supply. A change in price causes a movement along the supply curve, which is a change in quantity supplied due to a change in price. Figure 5.3 is an example of a supply curve along with its supply schedule. Supply curves include all the sellers of a good or service.

As with demand, variables aside from price affect the willingness of sellers to supply a good or service. Variables that can change the quantity of a good supplied are the cost of production, returns from alternative activities, seller expectations, technology, natural events, and the number of sellers. For example, if the costs of producing rice rise, the quantity of rice supplied for a given price would decrease. When the return from producing other goods, such as tea, rises, it reduces the quantity of rice supplied. If oil producers expect the price of oil to rise in the future, the quantity supplied in the current period will decrease as they expect higher profits in the future. As technology improves, the cost of production decreases, which increases quantity supplied of a good or service. Natural events, such as droughts and storms, affect agricultural production and decrease the supply of agricultural goods. When the number of sellers of a good or service increases, the quantity supplied also increases. When a change in one of these variables increases the quantity supplied, the supply curve shifts to the right, and when a change in variable decreases the quantity supplied, the supply curve shifts to the left.

Equilibrium

How do we explain the market price and the quantity of a good produced? Though the interplay between the different variables that affect the quantities demanded and supplied of a good is complicated, the logic of the demand and supply model is simple. When the two curves are put together, we are able to find a price and a quantity at which the buyers and sellers are willing to settle. Figure 5.4 is a combination of both the demand and supply curves that together determine the equilibrium of price and quantity.

Thus, a change in one of the variables that shift the supply and demand curves will change the equilibrium price and the quantity demanded and supplied of the good. An increase in demand shifts the demand curve to the right, which raises the equilibrium price, while a decrease in demand will have the opposite effect. An increase in supply shifts the supply curve to the right, which lowers the price, while a decrease in supply has an opposite effect. These are intuitive effects.

Efficiency Versus Equity

In a free market that satisfies the efficiency condition, how is equity preserved? For example, if consumers indeed behave rationally and according to the marginal benefit rule, then the market will efficiently allocate a larger share of production to consumers with larger incomes. Is this fair? This is considered a normative judgment in neoclassical economics and leads to a debate of efficiency versus equity. Regardless of society's judgment, an efficient allocation of resources is preferred to an inefficient one. An efficient allocation maximizes net benefits, and these gains in net benefits could then be distributed in a way that leaves everyone better off than they would have been in an inefficient allocation. If something is unfair, it is not a result of efficient allocation of resources. Instead, it must be from the distribution of income, or in other words from distributive justice.

Islamic thinking is a total shift in paradigm, enabling us to move away from the abstract mainstream definition of efficiency and equity to a more down-to-earth definition in conformity with normative goals.³⁵ An economy may be classified as having attained optimum efficiency if it has employed the total potential of its scarce human and material resources to produce the maximum feasible quantity of need-satisfying goods and services with a reasonable degree of economic stability and a sustainable rate of future growth. An economy may be said to have attained optimum equity if the goods and services produced are distributed in such a way that the needs of all individuals are adequately satisfied and there is an equitable distribution of income and wealth, without adversely affecting work incentives, savings, investment, and enterprise activities.³⁶

Some Islamic economists argue that, even according to the mainstream definition of efficiency and equity, the tension between efficiency and equity can be relieved. A compelling case can be made that this efficiency-equity result is a logical consequence of rule compliance that leads to perfectly competitive conditions being satisfied. However, a more interesting case would be to demonstrate these results in the case where there is market imperfection as assumed by Bendjiali and Tahir.³⁷

Market Models

Market models vary greatly and span the spectrum from low to high level regarding market competitiveness. The most competitive model is the highly idealized form of competition called “perfect” by economists. It is this model that is assumed to achieve an efficient allocation of resources. The central characteristic of the model is that both buyers and sellers take the price as determined by the market through the interaction of demand and supply. No one firm and no one buyer can affect the equilibrium price. The assumptions of the model are that there are a large number of firms producing identical products, a large number of buyers, easy entry and exit, and complete information about prices in the market. In the short run, firms maximize profits by producing an output level at which marginal revenue equals marginal cost. In the long run, if firms are earning an economic profit, it is assumed that other firms will enter the market and will drive the price down until economic profit achieves long-run equilibrium of zero. If firms are suffering economic losses, firms will exit, which drives prices up.

At the other extreme, the least competitive model is the monopoly, where an industry is composed of a single firm and the price of entry for new firms is prohibitive. The firm in this model chooses a price and output to maximize profits, earning monopoly profits. Sources of monopoly power include high sunk costs associated with entry (very large capital requirement), restricted ownership of key inputs, government restrictions (patents, licensing, etc.), and economies of scale. To maximize profit, a monopoly firm produces at the quantity at which marginal revenue equals marginal cost. A problem with monopolies, however, is that the firm produces an output that is less than the efficient level and charges a higher price in comparison to a perfectly competitive firm. As a result, an equity issue is generated: The higher price reduces consumer surplus in comparison to the perfect market model, and the difference is transferred to the monopolist. Monopolies are typically regulated to prevent inequity and high prices.

In reality, all economies operate between the idealized extremes of perfect competition and monopoly. This situation is referred to as imperfect competition, where there are a number of sellers and at least one seller has some degree of market power. There are two types of imperfect competitive markets: monopolistic competition and oligopoly. Monopolistic competition is characterized by a number of firms producing similar but differentiated products in a market with easy entry and exit. Few firms dominating an industry and producing either standardized or differentiated products characterize oligopolies. There may also be substantial barriers to entry and exit in oligopolies. Strategic decision making is important for oligopolists to determine the best output and pricing strategies.

An important class of literature specifies appropriate binding rules for the operation of markets in an Islamic economy. While predating development of conventional economics by centuries, this economy resembles the defined characteristics of perfect competition. For example, Islahi, writing on the “economic concepts” of Ibn Taymiah, suggests that the latter, based on his understanding of the Quran and Sunnah, “had at least some of the conditions of perfect competition in mind” when expressing his views on the functioning of the market and “had a clear conception of a well-behaved, orderly market, in which knowledge, honesty and fair play, and freedom of choice were the essential elements.”³⁸ The implication is that if there is rule compliance in an economy, results similar, and potentially even more beneficial, to those achieved in the ideal model of a perfectly competitive economy will be obtained.³⁹

Given that markets in an Islamic economy mimic perfect competition, the profit maximization postulate can be applied directly to determine necessary and sufficient conditions for allocative efficiency. Under perfect competition, the distribution rule requires that each factor receives the value of its marginal product, a result that converges to the concept derived from the Islamic principle of justice, namely that each factor of production receives its just due. Benjiali and Tahir raise another interesting question under conditions similar to perfect competition: Is there any loss of efficiency if markets are not perfect.⁴⁰ Specifically, they consider the case of a monopoly operating in an Islamic economy.

Bendjiali and Tahir address the question of whether in an Islamic economy the operations of a rule-compliant firm with monopoly power result in loss of efficiency in resource allocation. Their answer is that it need not.⁴¹ They suggest three things:

1. Profit maximization as an efficiency criterion is useful in an Islamic economy.
2. Profit maximization does not mean a sacrifice of equity.
3. These assertions hold even if there are market imperfections.

In conventional economics, more often than not, it is thought that there is a trade-off between equity and efficiency. Market imperfections, it is argued, exacerbate the trade-off. While it can be demonstrated that in a rule-compliant Islamic economy without market imperfections both efficiency and equity are achieved, we address a more challenging issue. Following Bendjiali and Tahir, it can be demonstrated that even in case of a monopoly, allocation efficiency with equity is possible provided that the monopolist is rule compliant.

Realistically, even in a fully rule-compliant Islamic economy, existence of factors that can lead to monopoly power cannot be ruled out. These factors include technological ones, innovation, economies of scale, and external economies (location and economics of agglomeration), among others. The question is: How will a rule-compliant firm with monopoly power behave to ensure that both allocative efficiency and equity criteria are satisfied? The next theoretical construct provides a tentative answer to this question by assuming that a firm produces an output (Q) with two inputs, labor (L) and capital (K). It hires labor at the wage rate (w) prevailing in the rule-compliant market. It raises capital through an ex ante (before production and sale of output Q) profit-loss-sharing arrangement. The funds thus raised and the amount of capital purchased with these funds give the price per unit of capital (r). Being rule compliant regarding distribution, the firm knows that all profits must be distributed among factor inputs, including entrepreneurial effort subsumed under one or the other inputs.

There are three possible cases during the postproduction and sale of output:⁴²

1. Profits are exhausted by payments to inputs as agreed in the preproduction phase, π = wL + rK

   where

   1. π = profit of the firm
2. There are losses: π < wL + rK. In this case, the loss is shared among the equity holders based on preproduction profit-loss sharing arrangements.
3. There are excess profits: π > wL + rK.

The focus is on the third case, as the other two pose no particular challenge. Specifically, we ask: Is there a rule that a firm can follow in distributing excess profits that ensures allocative efficiency and equity? It is envisioned that there are two sets of factor prices: r and w in the preproduction and sale phase, and and in the postproduction and sale phase, respectively. The production function of the firm is assumed to be Q = f (L, K). . The firm's demand function is given by p = P(Q) and its revenue function (concave) is R(Q) = P(Q)Q. Its cost function is C(L, K) = wL + rK. The firm's profit function is thus π(Q, L, K) = P(Q)Q − (wL + rK). While the firm is committed to distribute all profits among factor inputs, capital (equity) has a prior claim arising from the preproduction profit-loss-sharing arrangement. Therefore, if there is any excess profit, capital has a prior claim to a share. The firm then operates under the constraint that:

(5.8)

In the preproduction phase, the funds available to the firm to pay labor are P(Q)Q − rK. However, if there are excess profits, the firm, based on its commitment to the rule of justice, knows that a share must be allotted to labor, thus ensuring that . Hence, the firm has an additional constraint that:

(5.9)

Subtracting from both sides of this constraint and taking all terms to the left-hand side yields

(5.10)

The allocative efficiency issue arises because distributing more than a fair share to either input tilts resource allocation in favor of that input in violation of justice and the no-waste rule (i.e., more of that input will be used than necessary). What is needed is a distribution rule that ensures justice and allocative efficiency; that is, the right amounts of inputs are used in production. To search for such a rule, the next problem can be formulated:

(5.11)

Subject to the constraints that:

(5.12)

(5.13)

(5.14)

With this formulation, the constrained optimization problem can be solved to arrive at simple rules governing distribution. As is demonstrated in Mirakhor, the rule requires , meaning that so long as the firm distributes profits such that this equation is satisfied, equity and allocative efficiency are ensured.⁴³

Role of the State

Some believe that when governments intervene, markets are prevented from achieving equilibrium and maximum efficiency. However, government intervention plays an important role when markets fail, there are monopolies, and firms collude to abuse their market power. In these cases, regulations and enforcement are required to achieve socially desired goals.

Antitrust policies, designed to prevent oligopolistic collusion and excessive market power, assess how firm behavior and market structures affect social welfare and the public interest. The rule of reason guides most antitrust policies today in the United States, as many laws are left open for interpretation. There is considerable debate concerning the appropriate reasoning in specific cases.

There are different schools of thought when it comes to regulation. Often the differences in opinion between the schools of thought lie in whether there should be more or less regulation. For example, one group believes that regulation serves the public interest and should be increased. Another group believes that the regulated firms are always ahead of the regulators and that the regulation is fruitless. Though it may seem obvious that governments are needed to regulate industries to protect consumers, some industries have seen improvements in consumer welfare from deregulation, such as airlines and natural gas. Examples of federal regulatory agencies in the United States include the Securities and Exchange Commission, which regulates the securities markets, and the Food and Drug Administration, which regulates food and drug products.

Establishing a comprehensive socioeconomic restructuring to incorporate desired Islamic goals and minimize existing imbalances may not be possible without the intervention of the state.⁴⁴ This is because, even in an environment where values have been endogenized, it still may be possible for individuals to be simply unaware of the urgent and unsatisfied needs of others or be oblivious to the problems of scarcity and compromised social priorities. The Islamic state may therefore have to play a significant role in the economy. It may have to go beyond the generally recognized roles of providing internal and external security, removing market imperfections and failures, and devising comprehensive rules and regulations and monitoring their supervision. It may have to help create a proper environment for removing injustice in all its different forms and for realizing society's normative goals. This may have to be done without resorting to regimentation and the use of force or to owning and operating a substantial part of the economy. The state may have to determine social priorities in the use of resources and to educate, motivate, and help the private sector to play a role that is consistent with goal realization. It may accomplish this by inculcating moral values among individuals; by accelerating social, institutional, and political reforms; and by providing incentives and facilities. It may have to create a proper framework for the interaction of human beings, values, institutions, and markets for the realization of goals. In the end, it is preferable that rule compliance and enforcement come from individuals and not through state intervention.

The role of the state in an Islamic economy is not one of intervention, which is an unsavory term and smacks of an underlying commitment to laissez-faire capitalism. It is also not in the nature of the secularist welfare state, which, through its dislike of value judgments, accentuates claims on resources and leads to macroeconomic imbalances. It is also not in the form of collectivization and regimentation, which suppresses freedom and saps individual initiative and enterprise. It is, rather, a positive role: a moral obligation to perform a mission in compliance with Shariah to preserve and promote morality and justice in all economic decisions, keep the economic train on the agreed track, and prevent its diversion by powerful vested interests. The test of the Islamic state would be its performance in upholding the desired principles in a way that allows maximum possible freedom and initiative for the private sector. The greater the motivation people have in implementing Islamic values and the more effective socioeconomic institutions and financial intermediation are in creating the proper environment for a just equilibrium between resources and claims, the lesser will be the role of the state. Moreover, the greater the accountability of the political leadership to the people, and the greater the freedom of expression and the success of the news media and the courts in exposing and penalizing inequities and corruption, the more effective the Islamic state may be in fulfilling its obligations.⁴⁵

Summary

The study of microeconomics is crucial for any economic system. Regardless of the fact that normative goals in both Islamic and conventional macroeconomic systems are in general agreement, without a sound microeconomic foundation, these goals cannot be achieved. It is clear that problems such as poverty and obscene income disparity have not been solved in even the richest economies. The unrealistic assumptions of the conventional economic model and its distaste for value judgments have failed to achieve the well-being of all. It is for these reasons that conventional microeconomics needs serious reformulation.

Islamic economics is a rule-based system based on Shariah and has an alternate worldview to that of conventional economics. At the center of Islamic economics is socioeconomic justice, which makes the study of concepts more goal oriented than in conventional economics. Islamic economics argues that values are necessary and must be considered and that they are instrumental in achieving the maqasid. Though its precise formulation is still nascent, Islamic economics has already made valuable contributions to microeconomic thought and has provided alternate ways of thinking about the goals and behavior of the ideal consumer and firm.

According to Chapra, four steps are needed to complete the study of Islamic economics on a theoretical level to a point where it can be operationalized:

1. Study the actual behavior of individuals, groups, firms, markets, and governments.
2. Define the ideal behavior needed for goal realization.
3. Identify the reasons for the divergence of actual and desired behavior.
4. Suggest measures to bridge the gap between the actual and desired behavior in order to translate maqasid into a reality.⁴⁶

In an Islamic system, microeconomics can be modeled by changing human and firm behavior to comply with Islamic principles of justice, sharing, awarding factors of production their just reward, and so on, or by imposing a number of constraints to human and firm behavior that reflect Islamic requirements. In the next chapter, we turn to key macroeconomic concepts in both Islamic and conventional economics.

Key Terms

1. Consumer behavior
2. Theory of the firm
3. What, how, for whom
4. Production possibility frontier
5. Decisions at the margin
6. Needs versus wants
7. Utility maximization
8. Risk and profit sharing
9. Supply
10. Demand
11. Market equilibrium
12. Efficiency versus equity

Questions

1. Define “demand curve.” What is the law of downward-sloping demand? Why is there an inverse relationship between P and Q?
2. Define “supply curve.” Show that an increase in supply means a shift in the curve. What is the difference between this and an upward shift in the demand schedule?
3. What is the difference between a movement along the demand cure and a shift of the demand curve?
4. What factors determine the demand for rice in the conventional system? What additional factors come into play in the Islamic system?
5. What factors determine the supply of rice in the conventional system? What additional factors come into play in the Islamic system?
6. Describe why the equilibrium price settles at the intersection of the supply and demand curves (and movements away from equilibrium lead to a return to equilibrium)?
7. Why is a stable equilibrium important in any market?