FOUNDATION OF ISLAMIC ECONOMICS

(ECON 1710)

LITERATURE REVIEW ON

PROFIT: THE ISLAMIC PERSPECTIVE

SECTION 2

DR. MOHD NAHAR MOHD ARSHAD

Members:
1.

Sharifah Sukainah Al Munawar

binti Ahmad Al- Munawar

1324594

[email protected]

2.

Aqilah Al-Amani binti Shuhaimi

1325452

[email protected]

3.

Anis Suraya binti Mohamed Said

1321952

[email protected]

PROFIT: THE ISLAMIC PERSPECTIVE

A REVIEW
Abstract
This paper presents views on profit from Islamic perspective based on three main
points. Firstly, it clarifies the permissibility of profit maximization in Islam and in
what way that Islam allows for profit pursuance. The result found that education
regarding the issue becoming a suggested solution. Secondly, profit from Islamic
perspective is viewed by differentiating interest rate which is prohibited in Islam
with profit rate. A clear explanation from scholars regarding the issue of parallelism
between interest rate and profit rate is reviewed in the second part. Lastly, as profit
pursuance is allowed in Islam, this paper reviews the way to acquire profit without
involving in interest, which is via Profit and Loss sharing system.
INTRODUCTION
The obtainment of profit in business is needed as business cannot survive without profit. This
statement is accepted in Islamic economic system as economic activities and participation in
business have spiritual dimension in Islam. However, Islam does have its own prescription and
instruction in conducting the business and it is bounded by the rules that Allah had set. In recent
years, the study of profit maximization in Islamic context does not really exist. Therefore, this
study is conducted in order to address specifically about the concept of profit maximization in
Islam and how it is applied in the system. As a brief preview, this report is written by
highlighting three main points. The first is the concept of profit maximization in Islamic
perspective, where the ways to obtain profit is explained in the context of Islamic teachings.
Second, the use of profit rate system to replace the interest rate system in gaining income. The
last point is the application of the profit-loss sharing system in financial institution in order to
escape from the conventional system previously.
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1.0 PROFIT MAXIMIZATION

Production is one of the components of market in economic system. Productions goal is
to maximize the profit of the firm. The reviews below are about the theory of profit
maximization based on Islamic perspective. The papers that will be reviewed are: Islamic
Perspective on Profit Maximization by Abbas J. Ali, Abdulrahman Al-Aali and Abdullah AlOwaihan, Allocative Efficiency of Profit Maximization: An Islamic Perspective by Ruzita Mohd.
Amin and Selamah Abdullah Yusof, Advertisement & Islam: A Muslim World Perspective by
Adeel Bari and Rana Zamin Abbas. In these papers, the authors discussed about the
permissibility of profit maximization in Islam and the proper way of doing it.
1.1 Islamic Perspective on Profit Maximization
The journal begins with the statement on how religion and ethics could affect the
behavior of economic agents. Therefore, in this paper the authors tried to explain the concept and
practice of profit maximization by applying Islamic teachings and ethics.
The authors state about the importance of Islamic ethics in conducting business. Ethics
are demanded in business as it determines the boundaries of conduct and dictates the legitimation
of the economic activities. There are four foundations of Islamic ethics stated by Ali (2011) they
are, Ihsan which implies goodness and generosity in interaction and conduct, either at personal or
organizational level. The second one is Al-Din Al-Maamala means judging the action whether
it is right or wrong according to its benefit to people and society. The third one is equity, which
implies the fairness applied in the society so that the market players will have equal access to
market opportunities. The last one is responsibility which strengthens market trust and reinforces
commitment to business contracts.
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They also mention about the profit earning level in Islamic teaching. The main point
stated by the authors regarding the profit earning according to the contemporary scholars is that
profit maximization should not be the ultimate goal of the business, as the goal of profit
maximization solely will lead to the injustice practice in business and eventually will not serve
the welfare of the society. The scholars have agreed that profit acts as the essential means for
man to achieve the pleasure of Allah as well as al-falah in this world and hereafter. At the last
phase of the paper, the authors highlight on how Prophet Muhammad SAW states the conditions
for market transaction to be just. The conditions are, there should be no harm or harm-doer in
marketing exchange, for those who declare things frankly should not lead to each others
destruction and it is not allowed for anyone to take over the property of others without their
consent.
1.2 Allocative Efficiency of Profit Maximization
As the goal of Islamic Economics is to maximize the societys welfare, there has been a
criticism that the application of profit maximization is inconsistent with Islamic behavior.
However, the concept can actually be applied in the economy provided under certain conditions.
Therefore, the main discussion of the authors in this paper is on how the Islamic firm can still
achieve the desired outcome of an Islamic economy while ensuring the efficiency of the
resources allocation. In which, the allocative efficiency can be done through the valuation of its
opportunity costs where the firm takes into account the nature of the good to be produced.
The production in Islamic framework is viewed as the means not only to achieve material
satisfaction but also to attain goals in the hereafter. The authors also have quoted the guidelines
mentioned by Siddiqi (1992) regarding the pattern of production and allocation of resources that

must be followed. Some of the guidelines are, the prohibited goods and services are not supposed
to be produced, the production of refinement goods is small, therefore fewer resources are
supposed to be allocated to their production. As the result, more resources are to be allocated to
the production of necessity goods. In this paper, some simple theoretical models are presented on
how Islamic firm produces those outcomes while still maintaining profit maximization.
The authors also state some concepts in regards to production in Islamic framework. As
one of the goals in Islamic economy is to fulfill the basic needs of human beings, therefore the
allocation of resources to achieve those purposes is guided by the shariah. In shariah, Masalih
Al-Ibad (the welfare of human beings) is being emphasized. According to Al-Ghazali and AlShatibi, the social welfare is listed into a three-level hierarchy of activities or goods in order,
namely necessities, conveniences, and refinements (Ibn Ashur, 1998:210). Necessities consist of
the activities and goods that are essential in order to preserve and protect the five foundations in
humans life which are religion, life, mind, offspring and wealth. Conveniences are the activities
or goods that are not vital to the protection of the five foundations, but are needed in order to
eliminate difficulties in life. Refinements are the activities and goods that go beyond the limit of
conveniences, they serve to complement and beautify humans life. An Islamic producer will
treat the resources according to Allahs command and will base his production decision on the
concept of maslahah, meaning he can still be profit-driven but bounded by the shariah rules.
According to Islamic framework of production, the opportunity cost of producing goods must
take into account the nature of good produced relative to the other alternative goods. For
example, in producing necessity good that has a high maslahah, the opportunity cost is producing
a refinement good with low maslahah, therefore the opportunity cost of producing necessity good
will be lower and a higher profit can be achieved, and vice versa. Importantly, the only
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considered goods here are the permissible (halal) goods. In producing prohibited goods, the
opportunity cost will be prohibitively high, meaning that they should never be produced by
Islamic firm.
In the next section, the authors analyzed the profit-maximizing level in terms of
conventional and Islamic framework. The difference in the calculation of profit between the
conventional and Islamic system is at the calculation of opportunity cost, as in Islamic
framework the nature of the good produced by the firm relative to the other alternative good is
being considered, which is based on the maslahah. Thus, by assuming the same demand, the
costs in producing necessity goods are lower, the profit-maximizing output will be higher and the
price level will be lower in Islamic framework compared to the conventional. This means, more
necessity goods will be produced at a lower price which give more benefit to the society without
denying the firms profit-maximization decision. The same result happen in the competitive
market, for producing necessity goods in Islamic framework, the total output produced is higher
and the price is lower compared to the conventional. It is because more firms enter the industry
of producing necessity goods due to its lower economic cost, which resulting in the larger market
supply of these goods and pushing the market price lower than the conventional price. From the
analyses, it shows that the profit-maximizing behavior firm under Islamic framework ensures a
better allocation of resources with respect to the needs of the society.
The authors conclude the paper by stating that profit-maximization can be achieved more
efficiently in Islamic framework if the consumer also behave according to the Islamic values and
the government undertake certain measures to achieve the goals are also, so that the production
of necessity goods will rise in response to higher demand for these goods and hence, maximizing
the benefit of the society.
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1.3 Advertisement & Islam: A Muslim World Perspective

The overall discussion in this paper revolved around the issue of social and unethical
problem raised due to the materialistic advertisement done by the firm with profit maximization
as its main objective. The background place in this paper is specifically stated in Pakistan.
However, the review can be made in terms of the Muslim country, as Pakistan is a Muslim
country with 98% of the population is Muslim. The authors believe that the idea of capitalism
who promotes the free economical system motivate the business ventures to earn profit as much
as possible without considering the ethical and unethical aspects. Advertisement is one of the
ways the producers can use to promote their products and create the demand for the products. As
westernization is widespread, Muslim countries start to adopt the way the capitalist country did
their advertisement.
The authors defined advertisement as a unidirectional and paid form of communication
that is used to disseminate the products or services information, as quoted from (Wells, et al.
2007). The primary focus on advertisement is to enhance the business profitability, therefore
companies do not hesitate in investing heavily on advertisement and ignoring the social aspects.
Due to the negligence of social aspects in advertisement, the integration of ethical conduct in
advertisement is needed. According to Singh (2008), the main problem of contemporary
advertisement is the absence of any acceptable code of ethics, as ethics are the moral principles
that distinguish between right and wrong as well as good and bad. The authors agreed that the
need for integrating ethics in business is caused by the weakness of the law in covering the
problems.

The authors also address the way of the contemporary advertisement being presented is
not in line with the Islamic ethics. As the effectiveness of the firms advertising strategy
somehow determines the success of the firms performance, firms will try to attract the
customers towards their product using the best way possible. Here are some of the unethical
aspects conducted in contemporary advertisement. Firstly, the exaggeration of the features of
product advertised. This action is considered unethical as it is a form of deception towards the
customers and will lead them into misallocating their resources. In Islamic business ethics
honesty is considered as the most important thing and any form of deception cannot be accepted.
It is also related to the issue of the fairness in the advertisement. The fairness mentioned means
the quality and features of the goods that is advertised should be there in the product. As Islam
really upholds the value of justice, misleading people by showing them the overrated features is
considered as injustice and therefore it is prohibited in Islam.
Secondly is about the presence of nudity elements in the contemporary advertisement.
For example, the involvement of women in advertisement by exposing their body parts in order
to make the advertisement attractive. This is contradicts to the teachings of Islam and also
considered as a form of sexual stimulant and thus inappropriate for the public presentation.
Another issue is the advertisement of controversial products in Muslim countries. Controversial
product means the product that is considered sensitive by the society and sometimes contradicts
to the norms and culture of the society if it is to be advertised publicly, for instance the
advertisement of condom.
The authors point some effects of social problems on the Muslim countries caused by the
contemporary advertisement which neglect the Islamic ethical teachings. First is the loss of
cultural and religious values in the society. The example given in the paper is the free mixing
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between the opposite genders. Free mixing is considered unsuitable in the society, however as
the media keep promoting it through advertisement, it eventually become an ordinary thing
among the society. The result of the loss of the culture and religious values leads to the confusion
among the new generation about what is Islamic teaching and what is non-Islamic teaching, or
the identity crises. Therefore, the authors have prepared some suggestions in order to improve
these situations. First, the society needs to have a re-evaluation of its educational system by
having Islamic education be integrated as the syllabus in every subject and at every level of
education. Last but not least is the role of the authority in making policies that is compatible with
the Islamic business ethics such as restricting those advertisements that contain the elements that
against the culture or religion.
In conclusion, profit maximization is not prohibited in Islam and in fact it is encouraged.
However, it needs to be done within certain boundaries. Ethics of business should be
implemented in order to prevent any fraud and corruption to happen. Other than that, in making
profit the maslahah of the society need to be prioritized. Lastly, the method used in obtaining the
profit need to be in line with the shariah. The use of unethical advertisement and the application
of profiteering such as hoarding goods and monopoly in order to purposely increase the price of
the good excessively are really condemned, as it will cause harm to the society. Therefore, all
economic agents should work together in achieving the goal of the Islamic economic system.

2.0 RIBA' VS PROFIT RATE

2.1 AN INTRODUCTION TO THE ISLAMIC PERSPECTIVES OF CONDUCTING
BUSINESS
Ahmad H. Jumah and Raed N. Abu-Mounes (2011) views that the main issue arises about how
Islamic and conventional practices are differentiated is the interest rate. In the Quran, interest is
prohibited.
" Those who consume interest cannot stand [on the Day of Resurrection] except as one
stands who is being beaten by Satan into insanity. That is because they say, "Trade is
[just] like interest." But Allah has permitted trade and has forbidden interest. So whoever
has received an admonition from his Lord and desists may have what is past, and his affair
rests with Allah . But whoever returns to [dealing in interest or usury] - those are the
companions of the Fire; they will abide eternally therein." (Al-Baqarah: 275)
The authors in the article stated that interest or Riba' in Arabic is an increase in the original
value of a thing. For example, a Smartphone cost RM 800 now is sold with annual interest rate of
5% will cost RM 840 at the year end. Any default will increase the computers value absolutely.
Assume the same Smartphone is sold for RM 840 and it will be paid at the end of the year, this is
not considered as Riba in Islam. Prices of both are the same, but in Islamic views the treatment
is unequal because the interest dealing could vary the amount to be received after the year. On
the other hand, in the second situation, the amount is fixed and the buyer should not have to pay
more regardless of how the change in market situation happen. All contracts that contain
interests are prohibited. Interest is considered as a mean of bad business conduct and influence
the fair distribution of wealth.

10

There are other scholars' views about interest or Riba'. Abbas Mirakhor and Iqbal Zaidi
(1987) defined Riba' as the premium that the borrower must pay to the lender on top of the
principal, and it is sometimes put in simple terms as a return of money on money to emphasize
the point between interest rate and rate of return on a nancial investment: riba is prohibited in
Islam, but prots from trade and productive investment are actually encouraged. They also
emphasized that the objection is not to the payment of prots but to a predetermined payment
that is not a function of the prots and losses incurred by the rm or entrepreneur.
2.2

PARALLELISM

BETWEEN

INTEREST

RATE

AND

PROFIT

RATE:

COMPARISON OF ISLAMIC BANKING AND CONVENTIONAL BANKING

There are some issues pertaining the differences between interest rate that can considered as riba'
with profit rate that used by most of the Islamic bank. This article attempts to analyse general
arguments about Islamic finance and to be specific on the issue that there is no difference at all in
practices between Islamic finance and conventional finance since there exists parallelism
between interest rate and profit rate. Then, this article also tries to give clarification to doubts of
some people claiming that Islamic finance merely involves just change in name. In order to
prove their arguments against Islamic finance, these people create doubtful situation which
stating that there is parallelism between interest rate offered by conventional banks and profit
rate that distributed by Islamic financial institutions.
We can relate this with the history. The latest financial crisis seems to prove that
conventional financial system is not perfect. Islamic finance was becoming very popular after the
crisis since it has been declared as an alternative of conventional finance by some Muslim and
non-Muslim economists. After that the Muslim population in all countries started to prefer

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Islamic financial institutions more rather than conventional ones. It is in line with a simple rule
in the industry, there is a supply when there is a demand. Islamic finance is being practiced in
over 75 countries around the world with about 550 Islamic financial institutions included in the
sector. (Muhammad Ayub, Understanding Islamic Finance, 2007). Getting back on track,
according to the authors, the parallelism between distributed profit rates by Islamic banks and
interest rates declared by conventional banks is encouraging these deep doubts further. Since
Islamic finance is covering very small part of conventional finance world and it is trying to
survive in this world, this issue is an expected result. They come out with a result observed that
Islamic bank profit rates and conventional banks interest rates are parallel. They said that the
explanations about the parallelism between profit rates and interest rates are not convincing
people about Islamic finance in the contemporary current conditions.
In this article, the authors also clearly sense that the people who have doubts about
Islamic finance could not be persuaded because of this similarity between profit rates and interest
rates. They have opinion and such mind setting about Islamic finance that it is just another name
for interest-based system. There are some Islamic scholars and jurists say that since Islamic
banks are living in an interest-based financial system, normally the similarity between interest
rates and return rates will exists otherwise there will be no chances for Islamic finance to survive
in these economic system.
It is true that according to researches, the depositors who save their money in Islamic
financial institutions are similar to the customers of conventional banks in a way that they are
with an intention to maximize their incomes and wealth. Islamic banks are aware of this fact. So,
the Islamic banks think out to use profit equalization reserve which is done to protect the
depositors income against the reduction. When they believe the interest rates will be very above
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the return rates, they can utilize their reserve in order to increase the rate of returns. This reserve
is also significant to stabilize the rate of return to depositors by Islamic financial institutions. So
that if the bank declares a serious loss amount or even in the case of very low rates of profit, the
clients can withdraw their money saved in the bank before. The offered services by Islamic
banks or other Islamic financial institutions here may be quite similar to the conventional
financial system. It is does not necessarily mean that Islamic finance is just mimicking
conventional system when there exists parallelism between profit rates and interest rates, but
rather it is just a natural result of the recent situation.

2.3 RIBA', PROFIT RATE, ISLAMIC RATE, AND MARKET EQUILIBRIUM

Mohammed B. Yusoff (2013) in his article also said that Muslim economists have suggested the
profit rate to replace riba' in an Islamic economic system. But even this suggestion is considered
as a right directional step, it still has problem since not all profits are halal, as for example,
profits from liquor and tobacco businesses are definitely haram. The main issue that we can see
in this article discussed the concept of Riba' that differentiated from the profit rate and Islamic
rate. Since riba' is unlawful in Islam and is totally prohibited, this article explains the concept of
profit rate, which is permitted in Islam as it is derived from the profits of halal business activities
directly.
According to the author, the profit rate or Islamic rate is the clearing mechanism in the
money market and capital market. In an Islamic economic system, one of the basic
characteristics that have to be ensured is that it is free of riba' or interest rate. The profit rate will
depend on the economic performance of the Islamic economy over the business cycle. If the
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economy is in the down-swing, the profit rate is expected to be lower and the reverse is true
when the economy is in the up-swing. The Arabic word riba' referring to Mohammed B. Yusoff
(2013) is an increase in or addition to, but in practice riba' refers to the additional amount, in
excess of the principal, that a lender charges a borrower. The riba' system had been practiced in
the lending of money and barter trade activities since the pre-Islamic period. For example during
this time, whenever a person borrowed money from a lender, the borrower asked the lender to
extend the payment period and in return the lender charged the borrower a fixed amount of
money in excess of the original principal to be paid. During the time when Allah sent down the
revelations of the Quran on riba', there is a clear distinction between riba' and trade. It is
considered riba' in this following example; when a person sold an item to a buyer that would be
made aware of the period of payment, then the buyer failed to make repayment within that
specified period. He was then given more time to make the payment but with a charged of an
additional amount.

2.4

FINANCIAL

TRANSACTIONS

IN

ISLAMIC

BANKING

ARE

VIABLE

ALTERNATIVES TO THE CONVENTIONAL BANKING TRANSACTIONS

The scholars, Dr. Md. Abdul Jalil and Muhammad Khalilur Rahman (2010) in their article also
stated that Islam has prohibited riba (interest). When a lender lends money to another person, he
is allowed to get back the capital amount only but not any additional amount which is usually
fixed interest on the capital. Profit can be obtained from business in a lawful way but fixed
interest rate taken on loan given to a person is riba' and it is totally prohibited in Islam.

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According to them, the difference of riba and trade is that in trade there is a possibility
and occurrence of losses. In other words they said trade faces uncertainty in profit. It implies that
even the capital invested in trade is not assured to recover. A riba' contract, on the other hand,
highlighted by the authors can ensures the recovery of capital and finds a positive return which is
a fixed rate interest. Moreover, another fact emphasized by them that should not be ignored is
that profits are not predetermined as regards their size, unlike interest whose size is
predetermined and is part of the contract. There are some cases when a contract provides a
variable interest rate, but it is still considered different from profit rate in trade that is not at all
agreeable to contracting. In other words, there is no counter value to interest and there is always
a counter value to profit in trade. In our opinion, it is truly unlawful to lend out our money based
on interest rate whether it is for personal purposes or business purposes. We can invest the
money in trade, manufacturing, providing capital to others who in need or industry and involve
in profit and losses of the contract established.
2.5 AN ANALYSIS OF ISLAMIC BANKS' EXPOSURE TO RATE OF RETURN RISK
Zainol & Kassim (2010) in their article maintained that Islamic banks also face financial risks
similarly as the conventional banks but with some variations due to specific requirements to be
Shari'ah compliance. With regard to the interest rate risk, the Islamic banks could also exposed to
the same risk, known as the profit rate or rate of return risk as suggested by the Islamic Financial
Services Board (IFSB) (2005). So, the authors indicated that Islamic banks have to follow market
trend when the interest rate increases by also increasing the deposit rate. These clearly show that
there is a relationship between conventional banks' interest rate and the profit rate of Islamic
banks in which as the end result will give great implications on the management of risk of
Islamic banking system in Malaysia.
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3.0 PROFIT AND LOSS SHARING (PLS)

Islam prohibits interest but does allow the sharing of benefits of productive loan by the supplier
of funds if it is taken in the form of profit.1 The same verse of Holy Quran which prohibits
interest approves profit (Al-Baqarah: 275). Therefore, as conventional system accepts interest
(riba) as a source of profit, the view on profit from Islamic perspective surely contradicting from
the profit that is viewed and accepted in conventional system.
As a way to be free from forbidden elements (riba, gharar, maysir) in conventional
banking system, Muslim scholars took a long time to develop a banking system which is
operated based on shariah principle. The unique feature of Islamic banking which is profit-andloss sharing (PLS) concept is seen to be an ideal mode of financing in Islamic finance 2. Iman,
Toni and Jaenal (2010) emphasizes that PLS system is not exclusively Islamic as such system
can be found widely being used regardless whether it is Islamic country or not. But as the system
does comply with the teaching of Islam, it is adopted into the basis of Islamic Financial system.
Broadly, profit and loss sharing (PLS) is a contractual agreement between two or more
transacting parties, in which they agree to enter risky economic activities, and share the risk. The
returns, which might be profit or losses, are shared between the parties.
Hanif & Iqbal, (2010) in their join paper categorized Islamic modes of financing into
shariah based and shariah compliant. Sharia based which are Musharaka (partnership in capital)
and Mudaraba (partnership in capital and skill) are adopted by Islamic Financial Institutions on
profit and loss sharing basis. Under this mode, the return of financier is not fixed as it depends on
the successfulness of the project and loss is to be shared according to capital contribution.
1

Ataul Huq Pramanik, Islamic Banking How Far Have We Gone, 2006,
Dr. Md. Abdul Jalil, Financial Transactions in Islamic Banking are Viable Alternatives to the Conventional Banking
Transactions
2

16

While shariah compliant instruments explained by Hanif & Iqbal (2010) mean the financing
mode where the return or profit of financier is predetermined and fixed but within shariah
constraints. It consists of Murabaha (cost plus profit sale), Ijara (rental arrangement), Bai salaam
(spot payment for future delivery), Bai Muajjal (sale on deferred payment), Istasna (order to
manufacture) and Diminishing Musharaka (housing finance).

3.1 GAINING PROFIT FROM ISLAMIC INSTRUMENTS

This paper will continue reviewing journal by Hanif and Iqbal entitled (Islamic Financing and
Business Framework: A Survey: 2010) specifically on how profit is gained by using some
Islamic instruments.
1. Musharaka (partnership in capital)
Via musharaka, a join partners is formed to conduct a business in which partners share the risk.
The profit is shared according to pre agreed ratio while loss is shared according to the ratio of
contribution. Despite the conditions that must be fulfilled, the profit gained via musharaka is
permissible in Islam as the profit and loss are shared among partners with fair and just.
2. Mudaraba
Mudaraba also is a type of partnership but money and skill are brought together to run the
business. Similarly, profit is shared according to agreement but loss is only born by capital
provider. Under Mudaraba, IFIs provide capital to financially weak but skilful people to do the
business and share outcome with IFIs. This scheme is also used in deposit collection. Mudaraba
contract can be restricted or unrestricted. No one can claim a lump sum amount of profit it must
be based on actual outcome (Hanif & Iqbal, 2010)

17

3. Murabaha
Murabaha is a cost-plus sale in which the cost must be reveled to buyer. Under this system, say
person X requests to Islamic Financial Institution (IFI) to purchase an asset for him and sell on
deferred payment. The condition is that IFI must purchase the asset first before selling it to
person X. Bank can charge certain profit, and the recovery payment can be made in installments
or in lump sum. The amount installment cannot be stipulated. Penalty can be charge for prompt
payment but the payment cannot be included in income or profit, and it must be spent for charity.
4. Ijarah (leases)
Profit from ijarah is gained when IPI leases an asset to client and receive fixed rent payment
constantly whether monthly, annually etc. The ownership of asset belongs to bank but the
usufruct belongs to the lessee. Ijarah is different with sale in the way that ownership remains
with lesser while in the case of sales, the ownership is transferred to the purchaser. Also, there
are conditions that both parties have to abide, but ijarah is one of the way for an individual or
firm to acquire profit.

3.2 CAN PLS SYSTEM BE WELFARE IMPROVING COMPARED TO INTEREST

BASED BANKING SYSTEM?
A joint paper by Iman Sugema, Toni Bakhtiar and Jaenal Effendi in their journal (Interest
versus Profit-Loss Sharing Credit Contract: Efficiency and welfare implication, 2010)
attempt to answer the fundamental question of whether Profit and Loss Sharing (PLS) can
improve the aspect of welfare as compared to conventional system which is based on interest.
Even though the journal focus mainly on banking system, it somehow relate to profit; the main
discussion of this paper as bank also making profit, and customers are trading with banks to earn

18

income profit. Their paper first clarify that the economic consists of two groups; capitalist (who
own capital goods and does not work) and entrepreneur who owns labor and runs a firm. They
compare two situations in which the first one is under production certainty and competitive
market, both PLS system and interest based credit market resulted in the same price of capital.
Meaning to say, in the situation assuming that production is certain, both groups are neutral risk
agents and both capital and labor are indivisible, therefore PLS and interest based system are said
to be just and efficient. The assumptions being made to make the results clear and simple as
those situations are far from reality where both groups are more appropriate to be said as risk
aversion agent, and the indivisibility of labor and capital seems unrealistic.
However, when it comes to production under uncertainty, which is due to productivity
shock, they prove that only PLS system is just, as it distributes the risk at individual level
amongst lender and borrower fairly. Based on their theoretical and functional proof, interest rate
credit contract cannot be efficient and just when the shock is adverse or favourable for borrower.
That is because the borrower will have to pay more and for the lenders, in case of favourable
shock, they cannot exploit the excess marginal value product enjoyed by the borrower. Market
efficiency is also impossible to be achieved in term of individual borrower and creditor since the
risk is not being equally shared between them.
The discussion above brings an important implication toward income distribution. The
conventional system is typically favourable to lenders as they will not bear any risk. But this
brings an adverse impact to income distribution of borrower. Those facing favourable shock will
enjoy, and those facing adverse shocks should bear all the misfortune. In contrast, PLS system
provides the basis of risk sharing but it then will adversely affect income distribution among
lenders. Therefore, this journal came out with an alternative to overcome the problem. With

19

supportive argumentations, they suggest to provide an Islamic bank that act like a risk pooling
agents which absorbs all the risks faced by capital owner.

3.3 ADVANTAGES OF PLS

Apart from the journal above, there are many claims which discussed the advantages of Profit
and loss sharing system. This paradigm is said to be an ideal system to replace the conventional
one. Ahmed Kara in his journal titled (On the Efficiency of the Financial Institutions of Profitand-Loss Sharing; 2001, 2002) asserts that the presence of financial institutions of profit and loss
sharing within financial systems of countries could be considered a potential source of allocative
and dynamic efficiency. The rationality behind this is that, this PLS is able to bring into the
financial system new deposit. As a system which is in line with Islam been introduced, this will
encourage the person or society who been ambivalent with previous financial institutions and
tend to save their wealth in for example gold or other valuables form, to transfer their idle
saving into the financial system.
Nidai El-Ghattis in his article (Islamic Bankings Role in Economic Development: Future
Outlook : 2011) also points out that the Islamic profit sharing concept helps to stimulate
economic development by encouraging equal income distribution and which results in greater
benefits for social justice and long term growth. The profit-loss sharing scheme improves capital
allocation efficiency as a return on capital depends on productivity and the allocation of funds is
based on the success of the project. He also adds that the increase in investment will occur as the
PLS system gives depositors share in banks profit. Therefore, it will consequently results in the
increase in investment.

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Without denying that Islam does allow for profit pursuance, the way we conducting it
must be in accordance with the teaching of Islam. It is very grateful for us to have Islamic
Financial system today in which we realize that the establishment process before, did requires a
very great amount of efforts and hard work especially from Muslim scholars. Without all the
efforts, we might still be trapped in conventional financial system. However, the system we have
today is still in need for improvement and betterment. Humayon A. Dar and John R. Presley in
their article Lack of Profit Loss Sharing in Islamic Banking: Management and Control
Imbalances argue that whatever is the degree of success of individual Islamic banks, they have
so far failed in adopting PLS-based modes of financing in their business. Theoretically, PLS is
an ideal solution but to-date actual practice of Islamic banking is far from these models.
Humayon and John in mitigating the problem suggest that the incentive to cheat must be
eliminated, the desire to withhold information must be negligible and systems must be put in
place which allows efficient and open profit and loss share instruments to develop.

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CONCLUSION
In this paper, the concept and practice of prot are discussed and analysed in terms of Islamic
teaching and perspectives. Since Islamic economics system place significant emphasis on the
welfare and the continuity of the community, prot maximization or material pursuit is not
allowed for exploitation and mischief. Islam generally approves prot gains and lawful earnings
which do not lead to those misconducts. Therefore, profiteering or excessive gaining that will
give harm to the society are looked upon negatively. The evidences provided in this article
review prove that prot is in fact a positive outcome for nurturing economic well-being and
enriching the society's welfare. Furthermore, Shari'ah with respect to economic activities states
that any contracts or activities associated with interest rate are prohibited. It is because interest
prevents fair distribution of wealth between investors, and hence it is against the benefit of the
society.
Thus, in this issue we suggest that government as the authority should undertake the amanah of
ensuring that this goal is achieved by taking good measures, since in an Islamic economic system
the government should coexist with the market on a permanent and stable basis. Islamic financial
system also need for further improvement and betterment in term on practical conduct. The
instruments should be used with restriction and cautions to prevent resemblance to interest based
system, and to prevent them from being misused as a back-door to interest based financing. In
a long-term period, such measures should be in combination with a maintained effort to educate
all economic agents and create awareness to them of the proper Islamic values and finally
together with the importance of placing a high priority on fulfilling the society's need.

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