An open economy is an economy that is "open" to the flow of goods and services across its political boundaries. Such an economy engages in trade with other economies. On a global scale, an open economy is a country that engages in international trade with other countries. That is, the domestic sector exports to and imports from the foreign sector.
Trade between the domestic sector of an open economy and the foreign sector is governed by the law of comparative advantage, which means both sides of the exchange can benefit with a little trading. The open exchange of goods and services across national boarders also necessitates the exchange of currencies used by each country through what is called the foreign exchange market',500,400)">foreign exchange market.
The concept of open economy also applies to regions or areas within a country, such as cities, states, or counties. In this case the appropriate term is not "international" trade, but "interstate" or "interregional" trade. The domestic sector trades with its foreign sector, albeit primarily comprised of citizens of the same country. Moreover an exchange of different currencies is not needed. But the basic trading process is much the same.
Gains from TradeThe law of comparative advantage compels sovereign nations to open their borders and engage in trade with other nations. The law of comparative advantage states that every nation has a production activity that incurs a lower opportunity cost than another nation and that trade between the two nations can beneficial to both.
Trade between nations, like any voluntary market exchange, creates a net gain in the sum of consumer surplus and producer surplus. Buyers are typically willing and able to pay a higher demand price that the going market price. And sellers are typically willing and able to receive a lower supply price than the going market price. The sum of these two surpluses is the gains from trade.
The beneficial gains from such trading is what induces nations to open their economies and trade with other nations. That is, if one country can purchase a good more cheaply from another country than the cost of producing it domestically, why waste domestic resources on production?
Transit CostThe cost advantages gained from trading with other nations, however, must be weighed against the cost of transportation. While another country MIGHT be able to produce a good more cheaply than domestic production, the cost of importing the good might totally eliminate any possible gains from trade.
For this reason, an economy is open only to the degree that it incurs relatively low transit costs for importing and exporting. It a country is physically isolated from other countries; has natural or artificial barriers to entry and exit; or has no harbors, airports, or other transportation terminals; then the transportation costs are likely to be high and the economy is less likely to be open.
The Closed AlternativeThe alternative to an open economy is a closed economy. A closed economy is a nation that does not engage in international trade. The country has neither exports nor imports and no other economic interaction with the foreign sector. Its borders are effectively "closed" to the rest of the world.
While examples of closed economies populate the historical landscape, virtually all economies in the modern world are open and engage in assorted forms of international interaction, particularly international trade. The question is not so much one of open versus closed, but the degree of openness. Some open economies engage in only limited interaction with their foreign sector and are largely self-sufficient. Others engage in a great deal more international interaction.
Large economies, like that in the United States, tend to more self sufficient that smaller economies, such as Denmark, and thus engage in relatively less international trade. For this reason smaller economies tend to be relatively more open than larger economies.
Looking for WorkThe international trading of goods and services, exports and imports, is one sign of an open economy. However, an open economy is also open to the flow of resources -- especially labor and capital.
- Labor: The movement of labor, generally termed migration, flows into and out of an open economy. The flow of labor into an economy is termed immigration and the flow out is termed emigration. The movement of labor is largely in response to wage differentials between economies. That is, workers are attracted to higher wages. Labor migration tends to be controversial particularly when it involves the immigration of workers (and their families) from lower wage economies with different cultures, languages, and ethnicities.
- Capital: The movement of capital is essentially investment. While the flow of physical capital can and does occur, the flow of financial capital is quite common in open economies. Financial capital is the funds used to purchase physical capital, and is much easier to "transport" than physical capital. The flow of financial funds into and out of open economies is termed foreign direct investment. The flow of funds INTO an open economy means foreign citizens gain ownership (and often management control) over physical capital, something that concerns domestic citizens.
Trading CurrencyThe flow of goods, services, and resources into and out of an open economy necessitate the exchange of domestic currency and foreign currency. The purchase of exports, for example requires that domestic buyers trade domestic currency is exchange for foreign currency. The sale of imports, in contrast, requires that foreign buyers trade foreign currency for domestic currency.
The exchange of currencies takes place through the foreign exchange market. The foreign exchange market is a theoretical model of the exchange of currency (often termed foreign exchange) between nations. In the real world, the foreign exchange market is actually a number of markets, each for the exchange of currency between any two nations. For example, one foreign exchange market exists for the exchange between United States dollars and Mexican pesos, another for United States dollars and Japanese yen, and yet another for Mexican pesos and Japanese yen.
Protecting the HomelandOpen economies are generally beneficial for an economy. On balance, the movement of goods, services, and resources tend to promote consumer satisfaction, increase living stands, and enhance the efficient allocation of resources. However, not everyone benefits.
While the vast majority of consumers in an open economy are usually better off, producers that compete with imported goods are usually worse off. To the extent that domestic producers have more political clout that domestic consumers (which is common), the domestic government sector is convince to enact protective policies.
Some of the more common protective policies are trade barriers that restrict imports, including tariffs, import quotas, and other non-tariff barriers. Other protective policies restrict the immigration of labor or the foreign ownership of physical capital.
Such protective policies are detrimental to an open economy by reducing consumer satisfaction, reducing living standards, and inhibiting the efficient allocation of resources. However, they can provide other benefits including national security, domestic employment, and a more favorable balance of trade. On net, protective policies might be good for the domestic economy or they might be bad.
OPEN ECONOMY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: October 25, 2020].