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Contracting Agreements in Fairness

Updated on April 13, 2017

One common criticism of economics is that it focuses too much on efficiency, and not enough on things like equality, fairness and the welfare of future generations. In the extreme version of the criticism, the focus on efficiency is a deliberate plot to keep resources in the hands of the wealthy.

The economic definition of efficiency — also called Pareto efficiency, after the Italian economist Vilfredo Pareto — is easy to understand. Basically, it is just the same thing as gross domestic product. The more things we produce — including goods like TVs and cars, but also services like insurance and internet — the fewer resources we are wasting. Perfect efficiency — called Pareto optimality — is a situation in which the economy is so efficient that it’s impossible to give one person more without taking something away from someone else. In other words, perfect efficiency is a world where there really is no free lunch. Efficiency is able to capture how many economic arrangements are suboptimal. And as a result, new policies formulated with efficient institutions really can make things better for everybody. The real strength of the efficiency concept is that it focuses on gradual improvement. Instead of trying to radically reorganize society from the ground up, efficiency focuses on finding institutional or policy tweaks that make everyone just a little better off.

On the other hand, the most obvious flaw in the efficiency concept is the question of time. By producing more today, we leave fewer resources for the future generation — a policy that is Pareto optimal today may be robbing from our unborn grandchildren. Thus, static efficiency, or efficiency in the present, is not always the same as dynamic efficiency. Economists must take a stand on which one they care about when the two are in conflict. As inequality becomes a more important issue in the advanced economies, economists can no longer afford to ignore the trade-off between efficiency and equality.

Contractual Agreements and Fairness in Islam

In general, Islam secures all worldly activities, including economic transactions, on contracts. The Primordial Covenant[1] between the Creator and humans — the Mithaq — is basically a contractual agreement between creation and the Creator, which imposes the obligation on humans to recognize the Creator as their Provider and Sustainer (Rabb). From an operational standpoint, that cognizance is an affirmation that in their conduct on the earth, they will comply with the rules prescribed by their Cherisher Lord. Faithfulness to the terms of all contracts entered into, establishing justice, reward for rule compliance and punishment for rule violation on the Day of Accountability are linked to the fulfillment of obligations incurred under the stipulation of terms and conditions of the Primordial Covenant. This proposition links humans directly to their Creator and to one another.

In a direct, clear, and unambiguous verse, the Qur’ān commands: “ ... fulfill the Covenant of Allåh,” (Qur’ān, 6:152). In an equally clear verse it generalizes this imperative to all contracts: “... fulfill all contracts,” (Qur’ān, 5:1). Thus, faithfulness to the terms of every covenant, contract, or oath to carry out obligations one has committed to become a reflection of the Primordial Covenant.

Contractual agreements are key enablers for trade and commerce which record mutually-agreed terms for execution or dispute resolution. The Qur'anic verses (Surah Al-Baqarah : 282-283) enjoins Muslims to put contracts in writing for fairness and accountability. As such, Muslim traders relied upon an Islamic legal and institutional framework for the purposes of accounting and accountability, while Muslim scholars defined legal norms and acted as mediators in commercial disputes. Possessing written records is vital to the efficiency and transparency of commerce and for monitoring trade and agreements. Islamic law is the central institutional framework of being Muslim, and its inherent legal framework dictates, among other things, the ethical norms of business behaviour, to form the foundation for trust, equality and fairness.

Contractual Fairness in Risk-sharing

The problem of risk sharing is recognized as that who should bear a loss when a risk occurs. Posner and Rosenfield (1977) have proposed that the risk sharing in the contract law result in a problem that which party would bear a loss if they could have foreseen that contingency. In other words, the problem are :

i. Which party can prevent or control the risk more efficiently and

ii. If the risk cannot be prevented or controlled, which party is in a better position to protect himself against the loss.

Endogenous risks are affected by the contract structure, so it is not sufficient to provide only variation and risk-sharing rules to achieve efficiency. Whole contract structure, which is composed of the structure of the initial contract, rules of variations and risk-sharing, has to be designed to prevent the generation of endogenous risks or from incomplete contracts. Endogenous risks occur when the contractor does not make efforts to achieve sufficient efficiency. If the principal should bear the risk, a variation to the contract should be imposed because imposition of the variation gives the principal incentive to make an effort to achieve efficiency. And as for the risks whose hazards do not belong to any party, a variation should be admitted, i) if the variation increases the efficiency, or ii) the variation can induce one party to behave in a manner to achieve efficiency while the other party bears the cost of the risk.

Although the draw of risk-sharing agreements can be strong theoretically, in reality, it is always burdened by actual returns and accomplishments. Despite an abundance of presentations and discussions on the topic, actual experience has demonstrated that they are challenging to execute, and the fact that there are already less risky (risk-transfer) existing practices. Also, risk-sharing barriers include high implementation costs, measurement issues, a lack of trust between contracting parties and authorities (regulators, government, etc.), and the absence of a reliable track record or suitable data capture of past performance. Hence the expectations of risk-sharing arrangements should be further defined.

This definition can be on a refined basis of performance. As such, the development of a performance-based risk sharing agreements should be better received. The investment community will benefit from clearer analysis and guidance on good practices for the design, implementation and evaluation of the arrangements. One of the benefits is in reducing ambiguity through additional data collection for improved resource-allocation decisions. They can be viewed as mechanism for reducing uncertainty through greater investment in evidence collection. Performance-based risk sharing agreements also have “public good” aspects, which should be considered from a policy perspective. In part that means that public authorities who negotiate and fund evidence-generating arrangements should make the results of that research public where possible for transparency and accountability. These agreements should also be evaluated from a long-run societal perspective in terms of their impact on dynamic efficiency. However, the evaluation of these agreements should exclude circumstances where the non-performance is not a contributor, e.g. market conditions.

Contracting for Unquantifiable Risk

Erbas and Mirakhor (2013) notes that the fundamental cause of the 2008 financial crisis was the negligent, immoral, even criminal behavior of some actors. They saw it as a breach of the social contract implicit in fiduciary responsibility and trust, which bore disastrous consequences, and is not compatible with the commonly shared morals that guide economic behavior across many cultures and faiths, including Islam. The fundamental principal of Islamic risk sharing becomes important because of the acknowledgement of such temptations and human penchants as well as uncertainty. Erbas and Mirakhor emphasize that Islamic risk sharing does not permit washing one’s hands off of the liability once a loan is made ex ante but one must remain a party to it until risks are realized ex post. Thus, it is not permitted to create derivatives of derivatives (exotics, toxics, etc.) and other highly complex products, and it becomes possible to know who owes what to whom for an ex post settlement of claims and liabilities. The extended set of rules derived from the Quran and Sunnah as well as the concept of the khalifah, supports this commitment to fiduciary and personal accountability, building and maintaining trust as well as dispensing and upholding economic and social justice. Furthermore, the availability of khiyar or options in Islamic contracts gives investors the option of continuing or halting or abandoning an investment to hedge against uncertainty over time, and decision makers may be willing to pay for such contractual flexibility. Marschak and Nelson (1962) argue that flexibility comes at a cost, such as the cost of accepting lower payoffs or the cost of delaying some payoffs into the future. They propose a measure of flexibility in decision making according to which the more the decision maker expects to learn from each decision outcome, the more he/she values flexibility. Sequential decision programs are ambiguous over time, and more so as the time horizon becomes longer. Erbas and Mirakhor note that splitting multistage investments, or implementing them as segmented decisions over time, as opposed to once-and-for-all decisions with an ex ante commitment for the entire time horizon, gives investors the option of continuing or halting or abandoning an investment to hedge against uncertainty over time, and decision makers may be willing to pay for such flexibility.

Do People Want Equality or Fairness?

In his just-published book, On Inequality, the philosopher Harry Frankfurt argues that economic equality has no intrinsic value. This is a moral claim, but it is also a psychological one: Frankfurt suggests that if people take the time to reflect, they’ll realize that inequality isn’t really what’s bothering them.

People might be troubled by what they see as unjust causes of economic inequality, a perfectly reasonable concern given how much your income and wealth are determined. We are troubled as well by potential consequences of economic inequality. We may think it corrodes democracy, or increases crime, or diminishes overall happiness. Most of all, people worry about poverty—not that some have less, but rather “that those with less have too little”. Frankfurt argues, though, that we aren’t really bothered by inequality for its own sake. He points out that few worry about inequalities between the very rich and the very well off, even though these might be greater, both absolutely and proportionately, than inequalities between the moderately well-off and the poor. A world in which everyone suffered from horrible poverty would be a perfectly equal one, he says, but few would prefer that to the world in which we now live. Therefore, “equality” cannot be what we really value.

Researchers have found that if you ask children to distribute items to strangers, they are strongly biased towards equal divisions, even in extreme situations. The psychologists Alex Shaw and Kristina Olson told children between the ages of six and eight about two boys, Dan and Mark, who had cleaned up their room and were to be rewarded with erasers—but there were five of them, so an even split was impossible. Children overwhelmingly reported that the experimenter should throw away the fifth eraser rather than establish an unequal division. They did so even if they could have given the eraser to Dan or Mark without the other one knowing, so they couldn’t have been worrying about eliciting anger or envy.

It might seem as though these responses reflect a burning desire for equality, but more likely they reflect a wish for fairness. It is only because Dan and Mark did the same work that they should get the same reward. And so when Shaw and Olson told the children “Dan did more work than Mark,” they were quite comfortable giving three to Dan and two to Mark. In other words, they were fine with inequality, so long as it was fair. What we see from studies of children and studies of small-scale societies is an early-emerging desire for fairness, and a particularly strong motivation not to get less than anyone else. But we do not find any evidence that humans or any other species naturally value equality for its sake. Hence fairness in contracts or obligations are important tenets of our social contract with each other where dispute avoidance is considered as a best way of dispute management process of resolving negative perceptions so that no one will submit to any terms that the crafty may impose. Conflict and harm cannot arise when fairness is achieved and dispensed. Every individual prefers to be treated with utmost fairness and it is an ethical responsibility to ensure that no one is harmed.

[1] "And (remember) when your Lord brought forth from the Children of Adam, from their loins, their seed (or from Adam's loin his offspring) and made them testify as to themselves (saying): "Am I not your Lord?" They said: "Yes! We testify," lest you should say on the Day of Resurrection: 'Verily, we have been unaware of this.' " (Qur'an 7:172)


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