Chapter 3

THE ISLAMIC ECONOMIC SYSTEM

Objectives:
This chapter aims to cover the following topics:
- Economic system definition, components, classification/ characteristics.
- Islamic Economic system general introduction, philosophical foundation,
operational principles and goals.
- Property ownership Definition and types, general principles and types of
ownership in Islam and implications for the Economic System
- Motivation/ incentives Definition, types and importance, relationship between
Islamic Worldview and Motivation, implications for rational behavior
- Organization of Decision Making Definition and types, the concept of Shura
and implications in Economic Decision Making
- Coordination Mechanism Definition and types, the importance of Markets and
the Importance of Planning.

Further Readings:
Gregory/Stuart (1992), Comparative Economic Systems ( chaps 2, 3)
Monzer Kahf (1998), Islamic Economic System A Review in Aidit
Ghazali/Syed Omar Agil (ed.), Readings in Islamic Economics, Longman, Kuala
Lumpur.
Sultan Abu Ali (1986), Islamic Economic System, Readings on Islamic
Economics, Islamabad.

29
In topic one, we have established the premise that every human endeavor is value-loaded
and that at the most abstract level, these values are derived from a worldview.
In order to organize various aspects of social life, societies form systems. These
systems include the political system, social system and the economic system. These
systems have at least three aspects i.e. the philosophical foundation, operational
principles and goals to be achieved. In order to achieve these goals; plans, strategies and
institutions are formed. An Islamic Economic System can be represented as follows:

WORLDVIEW

SUB-SYSTEMS FOR VARIOUS

ASPECTS OF HUMAN LIFE

POLITICAL SYSTEM ECONOMIC SYSTEM SOCIAL SYSTEM

Philosophical Foundation Operational Principles Goals

Tawhid Adl / Ihsan Socio-Econ Justice

Ibadah Takaful/ Taawun Growth / Development
Khilafah Responsibility / Accountability Efficiency / Stability
Tadhkiya Moderation Employment Generation

PLANS, STRATEGIES & INSTITUTIONS

Gradual Change, Riba free economy, Zakah and Baitulmal, Social Insurance, Faraid,
Market/ State Role, Al- Hisbah, Contract Based Economy, Determining Priorities

30
Before we delve into the nature of the Islamic Economic System we must first try to
understand the characteristics of the conventional economic systems.

SYSTEM
Everywhere around us we see different entities behaving in a particular way
corresponding to some other entities functions. Together they form a whole, and achieve
completion of a task, which they on their own would have found impossible to perform.

You might not have even realized that you yourself are a part and parcel of a number of
systems (look around and try to identify some!) Even your body itself is a complex
system made of different organs which coordinate their actions and work together to
allow the very existence of a system: you!

A system can be defined as a set or assemblage of things connected or interdependent, so

as to form a complex unity, a whole composed of parts in an orderly arrangement
according to some plan or a scheme.

There are a varieties of systems of which we humans are a part; social, economical, legal
and so on. Every system has three basic components. Firstly, there are entities or
components which work together to form a system. These components can be either
persons, state or groups, which are the agents of interaction within a system. The mode of
interaction within a system, (among the entities) forms the second component of a
system. Here, it is essential to realize that the entities in a system would not interact with
each other unless they have a common objective, which they believe, can be resolved by
working together. Thus, the goal, which could have been planned or ordained, forms the
third component of a system.

ECONOMIC SYSTEM
An Economic system is any assemblage of entities that interact with one another
according to a particular plan in order to fulfill the economic objectives of a society.

Assar Lindbeck defines economic system as a set of mechanisms and institutions for
decision making and for the implementation of decisions concerning production, income
and consumption. 1

There are at least three ways to look at an economic system. Firstly, we can classify the
systems based on Production (how to produce), Consumption (what to produce) and
Distribution (for whom to produce). Secondly, we can classify it based on the sectors in
the economy: agricultural, manufacturing, service etc. This approach is usually used in
government reports and other national level documents. Thirdly, we may classify the
1
The Political Economy of the New Left: An outsiders view. 2nd Edition ( New York: Harper & Row,
1977) p.214

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system based on the comparative systems approach, which describes the characteristics of
an economic system by comparing the contrasting features of the systems.

Using the comparative systems approach, we see that there are four characteristics that
differentiate the two main antagonistic systems, Capitalism and Communism. These
characteristics are: property relationship, motivation mechanism, organization of decision
making and the coordination mechanism.

CHARACTERISTICS CAPITALISM COMMUNISM

Property Ownership Private Public
Motivation Self interest Altruism
Decision Making Body Centralized Decentralized
Coordination Mechanism Market Plan

These characteristics can be blended, so there is a large variety of possible economic

systems, depending on how the characteristics are mixed. 2

In reality neither capitalism nor communism exists per se. Conventional systems are a
combination of both and whether it is termed as capitalistic or communist depends on
where it lies in the continuum.

Capitalism Communism

USA Welfare State China, N. Korea, Cuba

PERFORMANCE OF ECONOMIC SYSTEMS

How well is an economy doing? This is an often asked question, because only by
constant evaluation can one ensure that the economies are pursuing the right goals and if
so, to find out how far have they achieved in doing so.

Evaluation of the performance of the economic systems can be done on two bases.
Firstly, by comparing the models with the actual performance (ideals vs. reality) and
secondly by studying the factors which affect the working of the economies. These
factors may be put in an equation as follows:

Economic Outputs = f (Economic system, Environment, Policies)

2
Gregory, Paul. R., and Stuart, Robert C. Comparative economic systems. Boston, Mass.: Houghton
Mifflin, 1992, p.15

32
Thus we see that in order to evaluate the system based on the factors, we will have to
study each of the factors in the equation.

The first factor, i.e. the Economic System can be classifies based on the following
characteristics, as we have discussed earlier in the chapter:

- property ownership
- motivation
- organization of decision making
- coordination mechanism
-
The second factor is the environment which includes (a) Natural Resources and their
availability (b)Level of Economic Development (c) Size of economy (d) Labor and
capital inputs (e) Geographical location.

The third factor is the policies that a system pursues. The policies that a system pursues
are an outcome due to the inherent system or to the policies that were pursued earlier. It is
possible to have two countries with the same system but differing in the outcomes due to
different environment factors and policies pursued. Thus there is a need to isolate the
environmental factors and the policy factors.

The outcomes that result as a result of these factors need to be evaluated using a set of
performance criteria. The expected outcomes in different societies may be the same;
however, their meanings, priorities and ways to achieve these outcomes may differ.
Assigning them weights tends to be a selective process, as people do not agree on the
appropriate criteria and their relative importance, and even their meanings (they may
have to consider Growth vs. Distribution or Unemployment vs. Inflation).

Determining the national priorities differ from system to system. Where political power is
largely centralized, the prevalent political authority exercises the decisive control over
formation of national goals, and consequently the outcomes. In democratic capitalistic
societies, although the electorate may indicate a preference, pressure groups such as trade
unions and professional associations exert substantial influence. The problem is
compounded by the fact that specific goals can only be achieved by sacrificing, less
important goals. However, the nature of the trade-offs is not always clearly defined.

However, the generally applied criteria are:

Economic Growth
Economic Growth (measured in GNP or Gross National Product and GDP or Gross
Domestic Product) refers to increases in the volume of output that an economy
generates over time. It is most widely used indicator of economic performance, but it
suffers from severe measurement problems. In addition, there is an uncertain link
between the growth of output and increase in the quality of life. For example it
doesnt describe the quality of life whether the goods that the economy produces are
military goods or investment.

33
 Efficiency
This refers to the effectiveness with which a system utilizes its available resources, at
a particular time (static efficiency) or through time (dynamic efficiency).
Static efficiency is usually measured by productivity calculations (ratio of output to
input). Other tool used in measurement is Production Possibility Frontier (PPF) and
the shape of the movement.

Income Distribution
This is usually measured by the Lorenz curve and the Gini coefficient.
For Gini coefficient, the more the dashed line moves from the 45 degree line, the
more unequal the distribution. The Gini coefficient (with a range of 0 -1) is the area
between the dashed line and the 45 degree line, divided by the entire area under the
45 degree line.

Lorenz curve

In a capitalistic society, personal income is determined by the human and physical

capital owned and their prices in factor market. The central problem with regard to
income distribution is to what degree is it possible to reduce inequality without
retarding effort, capital input and risk-taking.

Stability
This refers to the absence of significant fluctuations in growth rates (losses of
potential output), maintenance of acceptable rates of unemployment and avoidance of
excessive inflation. The price level would likely be constant or rising slightly,
consistently in a stable economy.

Development Objectives
This is a combination of the above mentioned four, whose meaning and priority are
different for different economies. There may be other development objectives as well
based on the circumstances of the economy.

In an Islamic Economic system, all the above performance criteria are acceptable. But the
over-riding goal is to achieve socio-economic justice. One of the objectives can be given
priority over others at times, the prevailing circumstances will be the deciding factors.

34
COMPONENTS OF ECONOMIC SYSTEMS
Economic systems are based on certain philosophical foundations, which must be
translated into operational principles, which in turn are converted into plans and so on.
Plans, strategies and institutions must ensure that the operational principles achieve the
desired goals. Thus the main components of any economic system are:

Philosophical Foundations
Operational Principles
Goals

ISLAMIC ECONOMIC SYSTEM: GENERAL INJUNCTIONS

The Islamic economic system stems from the worldview of Islam. All aspects of human
behavior must be guided by the rules of Allah. The economic system is just one of the
many sub-systems (including political, social, etc.) of the various aspects of human life.
Indeed Islam does not classify economic system as a separate entity. It recognizes that the
economic system is in fact related with other systems social, political and cant exist
without others.

Nasr 3 says that in Islam, economics was never considered as a separate discipline or
distinct domain of activity. That is why there is not even a word for economics in
classical Arabic, the term iqtisad being a fairly recent translation of the modern term
economics in Arabic and having a very different meaning in classical Arabic where it
means primarily moderation and keeping to the golden mean as witnessed by the famous
book al-iqtisadfil-Itiqad of al-Ghazali.

According to Islam the material world is a way to God, not a diversion from Him and
thus improving material life within the boundaries of the Shariah is a means to attain His
pleasure.

The components of an Islamic Economic System emanate from the philosophical

foundation and the operational principles derived from them. Thus we can study the
system by studying the following:

Philosophical Foundations
The philosophical foundations of an Islamic Economic System are based on the
basis of a doctrinal stand towards God, man and life. The four interrelated
foundations are:
- Tawhid: Tawhid in its essence is negation of any deity and then accepting
Allah as the only sovereign power.
- Ibadah: Any act within the boundaries of Shariah done with the intention
of seeking Allahs pleasure.
- Khilafah: Khilafah or vicegerency is a concept whereby man recognizes
his duty as the servant of God and accepts his duty as the caretaker,

3
A Young Muslims guide to the modern world. Sayyed Hossien Nasr (1994). Mekear Publishers, P.J.
p.204

35
 manager of affairs of the earth with the main motive of gaining Allahs
pleasure.
- Tadhkiyyah: The process of economic activity must be seen as a process
that purifies the soul. It should not lead to greed or vice in general.

Operational Principles
The philosophical foundations of the Islamic Economic System must be translated
into a set of operational principles, which will constitute the social, legal and
behavioral framework of the system. While many principles can be derived, some
of the more important ones are given below.
- Adl/ Ihsan: While Adl means giving what is due, Ihsan goes one step
ahead to mean giving more than what is due. Ibn Taymiyah says, As it is
oppression to prevent people from doing what they want with their
property, so it is oppression to allow them to exceed their limits and
extend their rights to spill over other peoples rights. 4 Thus a balance
needs to be stuck between the interest of the society and the interests of
the individual. Production: Efficiency/Distribution: Proper evaluation of
factors and pricing of output, redistribution to those unable to secure
darruriyat through market forces.
- Takaful/ Taawun : The Islamic economic system should operate on the
principles of Taawun (cooperation), but competition in all good things
(fastabequl khairat) as in the verse of the Quran which reads:
- Responsibility / Accountability: The individual is responsible to the
society, but ultimately to Allah, who is the sovereign owner of all things.
- Moderation: Man in an Islamic economic system would be moderate
(ummatan wasatan) in consumption, production and distribution. In
consumption this would be reflected in the avoidance of extravagance or
parsimony; as consumers realize that consumption is not an end in itself
but a means to an end. In production this may be reflected in resources
allocation shifting towards dhururiyat (necessities) and away from
tahsiniyat (luxuries).

CHARACTERISTICS OF ISLAMIC ECONOMIS SYSTEM

Using the comparative systems approach, we now discuss the characteristics of an
Islamic Economic System.

Property Ownership
Property ownership (whether private or public) is a social/ legal relationship of an
individual or group with an object, involving a system of rules of accesses to, and
control of resources. Here it is essential to note that property is not a thing in itself but
a bundle of rights. J.M. Montias has written that, the word ownership refers to an
amalgam of rights that individuals may have over objects, or claim on objects or

4
Ibn Taymiyah, Al Hisbah

36
 services and that these rights may affect an objects disposition or its utilization. 5
Property can be private, public or personal. Furthermore, property cannot be equated
with private property since other forms of property such as public property is also
acceptable and legitimate form of ownership.

From the definition of property above, three parts can be discerned: object, subject
and content.

The object must be something of value permissible and capable of being possessed.
(Qadri, 1973) It may be corporeal (having a body) or incorporeal (e.g. intellectual
property such as patents, trademarks and copyrights). Thus the object can be
anything that can be owned, from gold mines to things like food, clothing and shelter.

The subject of ownership may be an individual, state or society. The system may limit
the ownership of certain objects to only particular subject. For e.g. the roads and other
related infrastructure can be owned only by the state. In many cases the subject of
ownership is a corporation, and the owner of the corporation could be any one of the
three.

The content of ownership deals with the rights and we add, corresponding
obligations/duties with regard to property. This is in contrast to the western societies
where rights are weighed against others rights i.e. where societies are rights based.
Rights include the right to own, posses, utilize, exclude others, secure income from,
dispose, obtain compensation if damaged and so on. The bundle of rights may differ,
including some of the above i.e. incomplete ownership or be a complete ownership.
These rights are conditional upon the obligations that ownership is permissible (no
haram property may be owned) , proper and constant utilization (e.g. no hoarding 6 ,
keeping the money idle), avoiding misuse, and meeting all obligations 7 (e.g. payment
of zakah). Some or all of the rights may be lost if the obligations are not met.

The Quran uses the term amwal (86 times) to refer to wealth _ property,
possessions, etc. most of the verses deal with the content rather than the object or

5
Montias, The structure of Economic System, p.116
6
Hadith: 1) Prophet said, It is enough for you in regards of amassing money that you have a servant and
means of transport in the sake of Allah (to be used in Jihad) [Ahmad & Sahih Al-Jami)
2) Prophet said, Woe unto those who are Mukhthirin(amassing huge wealth), except for her who
(spends) like this and this with the money (pointing his hands in all four directions, once to the right, once
to the left, once to the front and once backwards. [Ibn Majah & Sahih Al-Jami)
7
Hadith: 1) Prophet said , Beware of being miserly! For those who were before you were destroyed for
being miserly. It ( BUKHL, being miserly) ordered them to be niggardly, and they did, and also asked them
to sever their relations (of the wombs), and that they severed, and also ordered them to indulge in sin, and
they indulged in sin! [Abu Dawood]
2) Allah the Exalted and Ever high said, We have sent down money so that the prayer is
established and Az-Zakat is paid. Yet, if the son of Adam has a valley (of gold), he would like to acquire
another, and if he had two valleys, he would like to acquire a third. Only dust is what will truly fill the
stomach of son of Adam! Then, Allah accepts repentance of who truly repent.

37
subject, as it is the content aspects which acts as the moderating fector between the
individuals rights and the societys rights.

The Arabic term for ownership (milikiyah) does not appear directly in the Quran,
although various derivatives of the root word malaka appear 92 times. Malaka
means to posses, control, have power or authority over, and is usually used in
reference to God.

Islamic Vision of Property Ownership: As discussed in topic 2, in the process of

deriving Islamic Economics, we need to establish the Islamic framework for
specific areas in economics. In this case we are talking of property. Using the sources
of knowledge in Islam, we derive the following:
- Allah is the absolute owner of property as He created everything
(examples in 2:21-22; 2:115; 3:190-191; 7:6-7; 15:26). All His creations
are in a state of natural submission to Him in their own way. (examples
7:54; 22:18 and 24:41). Thus ownership of property is by default, Allahs.
- Man as abd and Khalifa has relative and conditional ownership. The
Quran indicates that Gods creation is meant for the utilization by man for
the betterment of mankind, but in accordance with Gods will. (3:32; 4:59;
2:21-22)
- Conditional ownership is manifested in the fact that an individual doesnt
have the authority to make bequests exceeding a third of their property.
Another example is the Quranic injunction that there is a share of others
the poor and the needy in your wealth.
- Man is responsible to society and accountable to God for his property.
The Quran indicates that property is one of the trials and man will be
rewarded according to his actions. (3:32, 4:59, 2:21-22)
- Labor and need are both legitimate basis for ownership
- Both private and public properties are legitimate kinds of property in
Islam. The relative mix between private and public property depends upon
interpretation of the economic vision related to property ownership, which
in turn depends upon the culture, values, environment and history of a
country. However, society must be bound by the Islamic Economic vision
and its component concepts, values, laws and norms in deciding upon the
relative mix between the private and public property.

Private Property: It is allowed in Islam as there is no Quranic ayah

or hadith that prohibits it. This follows from the legal maxim that
everything that is not prohibited is permissible. The law of
inheritance in Islam is another proof of the fact that it is allowed.
However, it must be conditional and relative. Another proof of the
permissibility is that property has to be acquired through labor and
Islam admits that man shall get what he strives for.
A person may have complete or incomplete ownership rights.
When having complete rights

38
 He has right to own, posses, utilize, priority, right to exclude
others, secure income from the property, ask for compensation
when damaged/ purchased, dispose
He is completely responsible to society or state and accountable to
Allah.
Conditions to maintain ownership are permissibility, proper
utilization, constant utilization, meeting all obligations.
Not meeting these conditions may result in losing some or all
rights.

Personal Property: Personal property is that meant for consumption.

This includes personal belongings, shares, houses etc. and is
permissible in Islam; although there are rules regarding its disposal
(inheritance).

Public Property: It is justified on basis of a hadith which states

water, fire, herbage and salt should not be privately owned. Ulema
have interpreted the hadith to mean water sources oceans, seas,
rivers; fire to mean sources of energy especially non-renewable ones
such as gas, coal, oil and electricity (many of them are accepted by
conventional economists as natural monopoly); herbage to mean
grazing grounds, parks, and so on; and salt to refer to the basic needs
of humans.

Access to and control over public property should be determined with

reference to public interest (maslahah al-ammah) which is one of the
major objectives of Shariah.

Public property can be subdivided into two categories, state owned and
common. State owned property refers to that property whereby the
state has complete rights it, and can decide to use it for public
interests. The state may delegate the management to private sector, e.g.
corporation, privatization. Individuals will obtain a return for their
effort but the object continues to belong to the state. The common
property refers to public parks, beaches and so on which are accessible
to all members of society equally.

Motivation
Incentives or motivation mechanism discusses how to make the subordinates act in
the way required. An effective incentive mechanism must fulfill three conditions 8 .
Firstly, the person who is to receive the award must be able to influence the outcome.
Secondly, the superior must be able to check on the subordinate and finally, the
potential reward must matter to the subordinate.

8
Montias, The structure of Economic Systems, Chapter 13

39
 Material incentives promote desirable behavior by giving the recipient a greater
claim over the material goods. 9 Such incentives have typically been dominant in
modern economic systems, although moral incentives, which raise recipients social
stature, are also being used increasingly.

In an Islamic Economic System, moral incentives promoting desirable behavior by

appealing to subordinates belief in Allah form the basis of motivation. The
motivation comes as a result of the extended time horizon, which does not limit the
rewards an individual receives to this earthly life, but to life after death. Thus the
rewards and punishments are not confined to what an individual receives are not
confined to the earthly life. Doing right and pleasing Allah becomes the prime
objective even if the person is not rewarded sufficiently on earth, the belief that he is
answerable to God makes its imperative that the person is motivated to do right even
when nobody is watching.

Material and moral benefits must be weighed together before deciding to embark on
an activity (e.g. invest on a project). Thus when an Islamic man makes a rational
decision he includes the spiritual benefits in the rewards. Whereas providing material
incentives are fully justified in Islam (the material world is a bounty from Allah and
man shall get what he strives for), the bounds of Shariah may not be exceeded in
seeking material benefits.

Organization of decision making

Economic systems are decentralized if decisions concerning the allocation of
resources are made primarily at low levels; they are centralized if decision are made
primarily at upper levels in the hierarchy.

Resource allocation decisions may be made at the lowest level ( an individual

operating an enterprise), at an intermediate level (a company or a branch/division) or
at a high level (the conglomerate corporation or a government ministry).

In Islam, there is an avenue for people to voice their views on important issues. The
institution of shura or mutual consultation enables people to air their views on
controversial issues before a decision is made. However, shura does not imply that
every individual will be consulted on every issue at all times. Mutual consultation
will decide the future course of action, but the decision must be within the limits of
the Shariah. This is evident from the life of the beloved Prophet himself. Sometimes
the Prophet asked the suggestion of others and followed, while at times, he asked and
did not follow. And yet there were other times when he decided on his own. Thus we
see that the opinion of the shura is not binding, however is one of the means whereby
the people participate in decision making. There is no bias towards either extreme
because there are different levels of decision making.

9
Gregory, Paul. R., and Stuart, Robert C. Comparative economic systems. Boston, Mass.:Houghton
Mifflin 1992, p.22

40
 Coordination Mechanism
In a market economy, the market through forces of demand and supply provides
signals that trigger organizations to make decisions on resource utilization. Although
consumer sovereignty is presumed to prevailing market economies, in practice
governments, public goods, externalities, market power of large concentrated firms
and other factors also exercise considerable control over resources allocation
decisions.

In a planned economy, planners make decisions. Decisions are made at the higher
level of hierarchy.

In the real world none of the two systems are present on their own. There is always
some degree of planning. Compared to central planning where authorities of decision
making are centralized, indicative planning is somewhat different. Here the market
serves as the principal instrument of resource allocation, but a plan is prepared to
guide the decision making. An indicative plan is one in which planners seek to project
aggregate or sectoral trends and to provide information beyond that normally supplied
by the market. An indicative plan is not broken down into directives or instructions
for individual production units; enterprises are free to apply the information in the
indicative plans they see fit, though indirect plans are often used to influence
economic activity. 10

An Islamic economic system largely supports a market mechanism for coordination

of economic activity. This is based on a hadith reported by Ibn Majah and Tirmidhi
on bread prices in Medina where the Prophet refused to intervene to set prices (of
wheat) saying, I dont want to have the blood of these men on my hands in the
hereafter because there was a shortage due to natural causes (drought).

However, the market must reflect Islamic norms and values in consumer/producer
behavior. The state does play an important role in ensuring that the rules of the
game, which are in many respect quite different from the conventional economic
systems, are being adhered to. One of the means of achieving this is the institution of
al-hisbah (which will be discussed in topic 4).

10
Gregory, Paul. R., and Stuart, Robert C. Comparitive economic systems. Boston:Mass.: Hughton
Mifflin, 1992, p17

41
Problem set:
1. What are the philosophical foundations and goals of an Islamic economic
System?
2. Discuss briefly the four characteristics of an Islamic economic system.
3. What are the types of ownership in Islam? Elaborate.
4. What is the relationship between market mechanism and planning in an Islamic
Economic system?
5. How does the Islamic worldview affect rationality in an Islamic Economy?

42