PLS ratios negotiability: A repeated game incentive mechanism approach

Abstract

PLS contracts in Islamic finance are fair economic practices as they focus on sharing profits and loss between the project’s participants. Despite its ethical dimension, moral hazards and adverse selection are the paramount risks in this type of contracts. In this paper we seek reducing moral hazards in the form of the entrepreneur’s effort shirking and if a project optimum lifetime can be identified. To answer these questions, we use a game theory approach in one stage and in a repeated framework. Under each scenario, the participants either fix the capital contributions or negotiate over the sharing ratio or vice-versa. We found theoretical evidence that cooperation can be sustained over a one period game. Cooperation can be sustained in a repeated game only if an appropriate monetary incentive is introduced. However, this incentive can only be given for a specific period before the project’s NPV starts to drop. Indeed, we managed to find that period, called duration, for which the financier NPV is maximized. This duration can be proposed to be used as the optimum lifetime of the contract.