Extended Model

The previous discussion attempts to extend the conventional theory of the firm, in which the legal dimension of the firm is left out. It is not possible, it seems to me, to theorize a purely technical relation between output and capital while omitting the legality dimension. In this section, we put back in the legal and another aspect of the firm in order to make the model more realistic. In so doing we go back to some basic accounting terms. This is appropriate because the question has to do with the balance sheet of a firm. Balance sheets are identities, which always and everywhere bring about equality between capital (K) and debts (D) on one side and assets (A) on the other, that is A≡K+D. It is understood, that the asset of a running firm is always greater than capital in value, or given that D> , it follows that A>K. Schematically:

Managers of firms are judged by the records of their actions based on their own responsibilities towards the shareholders. They are accountable for their acts, as they have been legally delegated the authority to run the business.

Their responsibility to the shareholders is not restricted only to earning ever-increasing rate of profit based on the commonly used meaning of ‘capital’ of the firm. Using economic terms, capital in this sense, mostly, refers to a set of machines. Rate of profit (the ratio of profits to capital), though a useful measure in its own right, as a measure to evaluate the performance of the management can be misleading for two reasons. (a) A set of machines with no other facilities cannot provide an environment suitable for labour to work. (b) As said above, the asset value of firms is normally greater than their capital. Using the ratio of profits to assets (fixed and net of depreciation) provides us with a better and more realistic measure for evaluating management performance than rate of profit. The reason for this is that management has under its control all the assets of the firm to do its job. Although this new ratio, for the reason given, would normally be less than the previous one, it is more compatible with realities. This argument emphasizes that the responsibilities of management go far beyond the shares of the shareholders. In our extended model it is the value, arrangements and the types of the assets of the firm which form the environment in which the labour works, not just capital, usually defined as sets of machines or ‘a sum of money.

In an Islamic framework where PLS contract is used, as soon as the contract is signed with an Islamic bank both capital and asset values of the firm increases by the same amount. Hence, our model extends to cover such situations. Furthermore, even in the debt-capital case it adds the debt value of the borrowing firm with the same impact on its assets, in line with the fundamental principles of accounting. Machinery, tools, and other equipments constitute only a fraction of the total assets of a firm. To make economic theories more consonant with real life, economists need to make it clear what they mean by ‘capital’ of a firm. Does ‘capital’ to an economist mean the liability of the institution of the firm (a legal entity) to its owners (real entities) or to the market value of the firm? What will happen to the rest of the ‘capital’ defined as the difference between total assets and debts? Does this discrepancy or does it not contribute to the production of commodity? Are they redundant? If yes, what is the logic behind purchasing them in the first place?

Answers to the questions just raised, and many others, show that items other than those related to the initial capital put into a firm have their own contributions in producing output; however important, they are not accounted for by economists. Profit maximization prevents any expenditure unless the benefit outweighs the cost.

The proper measure to use for the production function can be written in the form:

(i) All asset items such as machines, land, buildings, warehouses, and others, are put together as one inclusive item with their own productivities being accounted in the process of production.

(ii) Integration of all asset items means that their contributions to producing output, contrary to the usual method, are dependent on each other. (iii) Most important of all, it is the value, arrangements, and the types of assets that not only make the production function, f, meaningful but also transform the legal aspect of the institution of firm into its technical aspects. We have tried so far to come close to some accounting terms and use their treatment of capital and assets in the balance sheet. We can make further use of them and redefine investment (I) as any positive change in the value of net fixed assets (A), (hereafter, just assets unless otherwise specified)

Source: Prof. Iraj Toutounchian, Integrating Money in Capital Theory: A Legal Perspective Towards Islamic Finance. Republished with permission.