PRINCIPAL-AGENT PREFERENCES IN IMPERFECT MARKET: THEORETICAL ANALYSIS ON MURABAHAH AND IJARAH

Abstract

This paper aims to determine the optimal contract for the principal and the agentin imperfect market, when murabahah and ijarah are used. The financial contractingenforceability approach is employed to determine the contract that maximizes thevalue of the firm subject to agents’ constraints when the shock is low and high, andregarding market frictions. Furthermore, this approach allows us to assess the level ofmarket frictions that agents may bear in case of low shock and high shocks. Findingsreveal that the simulated values of the market frictions’ parameters for both contractsincrease when moving from the low shock to the high shock. Such evidence impliesthat the agent is more likely to cheat and hide significant information about the projectwhen the shock is high. As a response to this higher risk, the simulated values of theprofit margin parameters for the principal rise also when the shock is high in orderto compensate for the increase of market frictions and mitigate conflicts of interest.By comparing both contracts based on the simulated optimal values of the firm, it isnoticeable that the gap between both contracts is very tight, which can be attributedto their common debt-based financial arrangements. However, the results show thatijarah allows the principal and the agent to generate the highest value in case of lowshock and high shock, comparing to murabahah. Therefore, ijarah seems to be moreattractive for the principal and the agent than murabahah.