Download Factors of Production and Factor Markets in Islamic Framework

JKAU: Islamic Econ., Vol. 6, pp. 37-40 (1414A.H./1994A.D.)
M. Fahim Khan
Factors of Production and Factor Markets in Islamic Framework
JKAU: Islamic Economics, Vol. 2, 1410/1990, pp. 25-46.
Comments:
Muhammad Akram Khan
Director General (Training), Department of the Auditor General of Pakistan,
Lahore, Pakistan
Dr. Fahim Khan's paper critically examines the conventional method of classifying
the factors of production into land, labour, capital and entrepreneurship. It offers an
alternative method of classifying the factors of production into two main categories,
viz., Hired Factors of Production (HFP) and Entrepreneurial Factors of Production
(EFP). The criterion for classification is whether a factor will get consumed in the
process of production or not. If it will not be consumed, then it can be hired for a fixed,
pre-determined rent which can be called ujrat. But if it gets consumed in the process
like raw material, or money, then it cannot be hired for a fixed return. It can only
receive a return by assuming risk. Thus finance cannot get a fixed return as it gets
consumed in the production process. This is the reason Islam does not accept interest on
capital as a legitimate return. The paper also analyses how these two factors of
production will get their shares and how the factor markets will operate. To the extent
the paper discusses the rationale for not allowing interest on capital and the reason for
not treating it as rent of capital, it is a valuable contribution to the literature. But the
paper also suffers from a number of ambiguities and contradictions which need to be
resolved.
Author's Observation on
Conventional Classification
The author has criticized the conventional classification of factors of production but
has left some questions either unanswered or touched them too briefly. For example, he
says: "... there is no theory on how the entrepreneurial profit is determined." (p. 26).
This may be true. But the author has also not developed any theory of profit. He has
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also treated the share of EFPs as residual after paying rent and wages. Similarly, the
author says: "The conventional theory does not recognize money capital as an explicit
factor of production but recognizes interest as a reward of capital." (p.26). This is not
precisely so. The conventional theory does recognize capital as factor of production but
it does not have a rational basis to assign a fixed pre-determined rate of return.
Furthermore, the author says: "The basis of distribution of the share of output is the
same for the first three factors of production land, labour and capital. The basis of
marginal productivity. Such a classification that requires the same basis for determining
the rewards of all factors of production cannot be considered very meaningful if
distributive justice is to be studied." (p.27). The observation is quite valid. But it applies
to the author as well who has developed his own analysis on the basis of marginal
productivity. He talks of determination of ujrat by supply and demand and on the basis
of marginal productivity of HFPs (p.39). How does the Islamic model differ from the
capitalist model? The only difference is that capital does not get a fixed return in the
Islamic model. Otherwise the author retains the assumption of perfect competition (and
implicitly, that of perfect knowledge). The author's concern for distributive justice
remains valid for his Islamic model as well. The wage of the labourer is determined on
the basis of his marginal productivity. The author does not show how his model will be
more just.
Islamic Classification of Factors of Production
While looking at the author's suggested scheme of classification of factors of
production in the Islamic framework, one wonders whether all this labour is
worthwhile, especially when we do not depart from the analytical framework of the
conventional economics. See, for example, the question of non-consumability of HFPs.
The labour of a worker is non-consumable while that of an entrepreneur is consumable.
Why? Moreover, it seems a bit queer to treat labour as non-consumable. The time of the
labourer is, perhaps, the most perishable of all resources. It cannot even be regenerated
while capital can at least be re-generated. The fact is that the author him self applies
different criteria at different places. He clubs capital and entrepreneur ship together
since neither of them, to his mind, are consumed in the process of production. But he
deviates from it in the case of rent of trees and milch cattle because "they generate
benefits in the form of real goods." (p.33). So another criterion comes in.
It will be more realistic to say that fixed tangible assets can be rented. Human
beings can earn wages for their services, if they do not want to assume risk. The capital
can earn rent if is in the form of physical assets. It can earn profit, if it assumes the risk
of loss. The entitlement of the entrepreneur to profit is also due to his willingness to
assume risk of loss. Thus stated, we shall not have to deviate from the four-factor
classification commonly accepted. We shall only need to explain why we cannot
reconcile with the concept of a fixed return for capital. The matter will be simple to
understand and explain.
M. Fahim Khan: Factors of Production...
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Institution of Participation
The author asserts that the Islamic model encourages participation of various
factors of production while "there is nothing in a capitalist economy to impose
compulsion of entrepreneurial participation particularly between scarce and abundant
resources." (p.35). The evidence is that "in labour abundant developing countries
operating under capitalist system, bulk of the population in working age sits idle."
(ibid). While underscoring the Islamic encouragement for participation, the author
mentions the stimulating effect of zakat on investment. It would have been fair if the
author had shown the Islamic mechanism for absorbing the surplus idle labour which he
quoted as the evidence of the capitalist system's non-encouragement for participation.
The Effect of Social Insurance
The author has asserted that the institution of social insurance in Islam, which
guarantees a minimum standard of living for all will encourage people to take the risk of
becoming an entrepreneur instead of working at below subsistence wage. The assertion
seems plausible apparently. Let us take an example. In case people find that the wages
are too low, they will like to refuse wage-employment and try to move to EFP sector
where expected profits are higher. But soon the flow of resources into EFP will increase
the supply of labor in this sector. It will push down profit rates as well. In the long run,
the equilibrium level will be a point where the incomes of a person from profit and
wages are almost the same, taking the capital factor out for a while. How does the social
insurance, then, encourage entrepreneurship?
Operation of Factors Markets
The author has asserted that the HFP market will always be in equilibrium.
However, the supply of EFP market can exceed than what the economy can absorb. The
general situation may be what the author has predicted. But one can imagine a situation
in which HFP can also be in disequilibrium. Suppose, at certain point of time when both
the factor markets are in equilibrium, as a result of some technological breakthrough,
the demand for EFP suddenly increases. People will start moving to EFP from HFP. It
will, besides pushing up wages in HFP, create gaps in the HFP since some physical
assets which need human hands to operate will not find enough people to remain
employed. Thus a situation of disequilibrium in HFP could arise.
Some Minor Points
We shall now discuss some minor points about the paper.
First, the author thinks that money market is a prohibited institution in Islam (p.
30). Perhaps, it needs some re-thinking. We may be able to think of some useful
functions which this institution performs even though we do not treat money as a
commodity. The placement of funds on the basis of Shari'ah-approved modes could be
one such example.
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Second, while stating distinguishing features of the Islamic model, the author says:
"the supply of capital cannot be treated as a supply of savings which are generated in a
process of choice between present consumption and future consumption. The supply of
capital is now generated by the output of the capital goods and has no links with the
interest rate as is the case with the supply of other commodities." (p.34). But on p.41, he
defines the supply of factor of production (Sr) as resources determined by a "choice
between present consumption and future consumption in case of capital goods and
financial resources". There seems to be a contradiction between the two statements.
Third, the author says: "The restriction to make the finances available only on the
profit-loss sharing basis reduces the profits of big entrepreneurs because the entire profit
is now to be more widely distributed." (p.36). This need not be so. The actual
distribution of profit and its impact will depend on the profit-sharing ratio and the level
of profits. It will also have to be compared with the rate of interest. However, a similar
statement can be made about risk of loss.
Fourth, the author says: "An excess supply of monetary resources is hardly
conceivable in any capital scarce economy in general and in an Islamic economy in
particular." (p.43). This is obviously incorrect if we look at the oil-rich Muslim
countries.
Subject to our observations, Dr. Fahim Khan has written a very valuable paper. It
has taken the debate on this question a step further.