Economics of incentives

Incentives in trade and business must comply with Shariah rules.

LONDON: Incentives play an important role in generating economic activities of all sorts. Tax incentives and subsidies have traditionally been used as recognised fiscal tools for spurring economic growth. They are also used as macroeconomic measures for distribution of wealth and income.

Other forms of incentives may include possibility of winning huge sums of money in gambling, prizes in competitions (like TV quizzes, reality shows and business programmes like Dragon Den etc) and offering of prizes on sale of certain goods and services.

The incentives also play an important role in loyalty programmes as employed by many businesses. Cash-back facilities on certain transactions and reward points used by almost all airlines, including PIA, and retailers, like TESCO and Sainsbury’s in UK, are other examples of incentives. “Sales” by retailers with “Buy One Get One Free” offers are also used to increase sales by way of incentivising customers to buy more.

In USA, a number of competitions are held to promote innovation. The winning innovators receive not only cash prizes but also other benefits in terms of help in product development and sale and distribution.

The question arises if such an incentivisation is commensurate with Shariah rules on trading. To understand the essence of Shariah requirements, we take an example.

Suppose a retailer announces a cash prize of Rs10 million for its customers who buy a specific product. Those who buy a specific quantity of the product are allocated unique reference numbers, which enter into a draw and the winning customer receives the cash prize of Rs10 million. Is it Shariah compliant for the businesses to offer such schemes and for customers to enter into the draws that are used to determine winners?

The answer is yes, if certain Shariah requirements are observed. These requirements include:

1. The prizes must be offered to those who buy a Shariah-compliant product.

2. The prizes must be offered to only those who buy a good or service; those who merely buy a unique reference number to be entered into a draw are not eligible for winning prizes.

3. The businesses offering such prizes must not charge a higher price for the product the purchase of which entitles the buyers to enter into a draw.

4. Ideally the prizes (in cash or in kind) must be financed from independent sources and not from the direct sale proceeds. However, the prizes may be financed from the profit generated through sale of the product or from the general profit pool of the business.

5. It is binding on the prize-offering business to give prizes once the prizes have been announced and that the sale of goods and services has taken place. The business is bound to give the prizes even if the sale of goods and services has failed to produce profit for the business. In such a case, the prizes must be financed from the sources independent of the profit pool (eg personal wealth of the shareholders and directors).

Condition 1 requires that only Shariah-compliant goods and services be used for offering prizes. Hence, it is not Shariah compliant to offer prizes on the sale of alcohol and other impermissible things like pork, interest-bearing deposits (offered by conventional banks), because the sale of such goods and services in itself is Shariah repugnant.

Condition 2 disallows sale of pure lotteries, because it entails nothing but sale of a chance of winning (and losing), which falls under the prohibited gambling.

Condition 3 disallows a business to charge a higher price for the goods and services on the sale of which it offers prizes. Thus, if a can of Coke is ordinarily sold for Rs20, it is not allowed to Coca Cola Company to sell the can for Rs25 to the customers participating in the prize draw. If Coca Cola does so, it actually charges Rs5 for entering into the draw. This is prohibited because it falls under the prohibited gambling.

Conditions 4 and 5 require that the prize offering business must be capable of honouring its promise to offer the prize from the sources independent of the sale proceeds. As said above, the announcement of the prizes creates an obligation on the business to pay prizes even it fails to generate profits. In other words, the owners of such a business become personally liable to pay prizes if the business generates losses.

In the context of banking and finance, it is important to note that current accounts offered by banks cannot be used as a product on which the prizes can be given. However, investment accounts can be used to attach prizes with them if other above-mentioned conditions are met.

In summary, while incentives work in business transactions, it is important to observe Shariah requirements that ensure that there is no incidence of the prohibited elements related with interest, contractual uncertainty and gambling.

THE WRITER IS AN ECONOMIST AND A PHD FROM CAMBRIDGE UNIVERSITY

Published in The Express Tribune, August 13^th, 2012.