An open economy is one that interacts with the other economies of the world through international trade and engages in borrowing and lending through a global financial market. Most nations operate open economies to varying extents. Economists since Adam Smith and David Ricardo, writing in the 18th and 19th centuries, recognized the benefits of open economies for consumers, investors and nations as a whole.
Most countries today have an open economy. Their goods and services can be traded across borders, and most industries tend to be privately owned. Imports and exports account for a large part of the GDP. As a result, customers have access to a wide range of products from national and global brands. If you're an entrepreneur, it's important to have a clear understanding of the differences between open and closed economies. This will help you decide who to do business with and where to invest money for long-term success.
What Is an Open Economy?
In an open economy, people are free to sell goods and services to foreign countries. They also have the option to purchase goods and do business across the international community. The United States, Australia, Singapore, Switzerland and most EU countries have an open economy characterized by low trade barriers.
In the past, New Zealand, Canada and Australia had protectionist policies in place. However, they began to open up in the '80s and '90s, which led to increased revenue and productivity. Other countries have a small open economy, meaning that they engage in international trade, but their actions have a negligible impact on global prices.
For example, the Czech Republic, Austria, Belgium, Luxemburg, Norway and Jamaica all fall under this category. A country like Austria is too small to influence the global economy, including prices, income and interest rates. Therefore, it's vulnerable to the ever-changing global market conditions.
If a large open economy like Germany goes into recession, it will negatively impact the world economy. A recession in Austria or Belgium, on the other hand, is unlikely to have a major impact on other countries.
The degree of openness varies from one nation to another. Financial experts claim that there is no such thing as a completely open economy. Most countries have monetary and fiscal policies as well as trade barriers aimed to protect their economies. Some still have government-owned industries. Others don't allow free movement of capital across their borders.
Features of a Closed Economy
Not all countries are willing to trade goods and services with other nations. Even though few closed economies exist today, some countries still restrict the flow of resources across their political boundaries. In theory, these are self-sufficient and don't rely on international trade.
But which countries have a closed economy? A good example is Brazil, which has the lowest trade-to-GDP ratio in the world. Its economy is primarily based on its domestic market. There are fewer than 20,000 Brazilian companies that export goods. That's extremely low considering the large population. Norway, by comparison, has a similar number of exporters, but fewer residents.
According to the World Bank, Brazil has close ties with China, another closed economy. It's expected to become one of China's fastest-growing important sources. Even though both countries impose high tariff barriers on certain goods and services, significant progress has been made in this regard over the past years.
Despite being the world's largest exporter of goods, China has a closed economy because of its restrictions on imports. Furthermore, it enforces strict regulations concerning the use of technology within its borders. The imports of poultry and eggs are completely banned. Domestic cinemas are not allowed to run more than 34 foreign movies per year. Companies that plan to do business in China are subject to high taxes and import tariffs.
Governments and academics have long discussed the advantages and disadvantages of a closed economy. Some experts say that this type of economy ensures an abundance of labor. Additionally, these nations are self-sufficient and don't rely on the global economy. They also find it easier to regulate internal goods.
Countries with closed economies often lack the internal resources needed to produce certain goods. For example, they may not have enough petroleum, crude oil, coal or grains. Since the government controls prices, customers are forced to pay for goods that they may or may not be able to afford. If the country in question experiences adverse conditions, such as low rainfall, its population may starve. Farmers would lose their income, and the crops would die.
Other features of a closed economy include extensive government regulations, nationalized industries, protective tariffs and limited opportunities for growth. Countries that fall under this category are deprived of the benefits of international trade, such as the access to new technologies and innovative products. Their residents are not allowed to work abroad, while foreigners don't have the right work within their borders.
However, no economy is completely closed nowadays. This concept is mostly used for developing macroeconomic theories.
The Advantages of Open Economies
Collaboration drives growth. In an open economy, people can exchange goods and services, start or expand their business across borders and enjoy lower costs. Customers have access to a wide range of products that may not be otherwise available. The flexible economic environment ensures optimum allocation of resources and consumer sovereignty.
This type of economy encourages competition among domestic producers, which translates into higher quality products and lower prices. For example, a domestic furniture manufacturer will be competing against hundreds of local and global brands. As a result, the company will strive to offer better customer experience or superior products to gain a competitive edge.
Another advantage of an open economy is the ability to sell exports at higher prices and get cheaper imports. When two countries trade goods and services with each other, they'll both benefit from these differences in price. Additionally, the removal of tariffs results in lower costs for customers.
Entrepreneurship is highly encouraged as well. Those who plan to start a business can freely exchange information and resources with foreign companies. This allows them to keep the costs low and access the latest technologies so they can offer innovative products at competitive rates. Furthermore, they can supply goods that are not widely available on the domestic market.
The ease of doing business helps create more jobs. In industries where the competition is fierce, companies will seek to attract top talent and offer a higher salary, which in turn, stimulates the local economy. Furthermore, access to technology and know-how boosts productivity and innovation in the workplace.
Are There Any Drawbacks?
Despite their apparent advantages, open economies are far from perfect. First of all, they're vulnerable to external threats. Price fluctuations, market crashes and high unemployment rates in one country can spread to other economies. For example, the financial crisis that occurred in 2008 was followed by a global economic downturn. Millions of people lost their jobs or found themselves underwater with their mortgages.
In an open economy, many businesses may try to reduce their costs and maximize profits by exploiting employees or importing poor quality products and raw materials. Additionally, large organizations can dominate certain markets, creating monopolies and setting unfair prices. The increasing number of foreign companies can kill local businesses. On the other hand, the arrival of a large corporation in a small community could end poverty and increase employment rates.
While it's true that open economies have their share of drawbacks, they drive growth and innovation. The widespread availability of goods and services, as well as the ease of doing business and the flow of productive resources, may contribute to prosperity and sustainable development.
- Council on Foreign Relations: How to Be an Open Economy
- World Bank: Implications of a Changing China for Brazil - A New Window of Opportunity?
- Financial Times: The Cost of Brazil’s Closed Economy
- Investopedia: Closed Economy
- Reuters: Barrier to Entry - China's Restrictions on U.S. Imports
- Philadelphia Fed: The Economics of Small Open Economies