Profit ratio Negotiability model in Entrepreneurial Financing Using Game Theory and Agent Based Simulation as an Aid to Decision Making

Profit and Loss (PLS) sharing contracts in Islamic finance are considered to be fair economic practices as they focus on sharing profits and losses between the project’s participants. This mode, however, suffers from asymmetric information in the form of moral hazards and adverse selection. The purpose of this paper is to reduce moral hazards by developing an equilibrium profit sharing ratio’s span of negotiation in a PLS contract involving a financier and a entrepreneur. We aim to establish an agent based model that will help the financier decide whether to accept financing a contract. We make use of game theory techniques and we test our results using an agent based simulation tool (Netlogo). We found theoretical evidence that a Nash equilibrium span of negotiation, for both profit sharing ratios, can be developed which is both rational and incentive compatible to both participants. However, the simulation tool suggests that despite the existence of an average positive span of negotiaton , financial contracts might not be extendes if the number of void contracts in a simulation exceeds a specefied threshold. The usefulness of the agent based simulation tool has added value to our theoretical finding by suggesting when PLS contracts can or con’t be signed.