A Theoretical Analysis in Choosing Between Profit-Loss Sharing and Interest-Based Contracts: A Simple Game Model

Abstract

Purpose — This study aims to investigate how participants decide between profit-loss sharing contracts (PLSC) and interest-based contracts (IBC) in an interactive environment. PLSC and IBC are two interesting financial arrangements. They are similar in that both transfer money from people who have excess money to those who are in need, but they are extremely different in sharing risks between participants. Design/Methodology/Approach — The participants’ profits change based on their role (as an investor or entrepreneur) and the selected contract because the contracts are entirely different in sharing or shifting risks. Thus, in the first step, various profit functions are constructed that differ according to each party’s role and major factors relevant to each contract. Afterwards, a mathematical game model (GM) is developed to consider the parties’ interaction concurrently. A numerical example also verifies the results. Findings — The results show that the business output level, auditing costs, collateral related costs, and market conditions or state of the economy (SoE) are major factors in deciding between IBC and PLSC. Originality/Value — This research sets up various profit functions (based on players’ roles and contracts), enriching them by the contract-related factors and SoE and developing a GM. The existing literature focuses on the investor’s optimal contract, while concluding a contract needs the mutual consent of the involved parties, not only the investor’s inclination. Practical Implication — This research provides a guideline for ‘parties’ share in PLSC’ and generally accepted auditing standards for auditing PLSC.