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Economics: Closed Economy versus an Open Economy


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About this Lesson

  • Type: Video Tutorial
  • Length: 8:56
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 96 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: International Focus (25 lessons, $43.56)
Economics: Microeconomics Background (4 lessons, $8.91)

In this video lesson on economics, you'll learn about the difference between a Closed Economy and an Open Economy. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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The last time we talked about the market, we put the supply and the demand together and came up with the equilibrium price and quantity traded. That was a case where the market was closed to trade; that is, all the supply and all the demand were within the economy. This time, we're going to study international trade. We're going to use the supply and the demand diagram with one addition: in the case of international trade, we're going to consider a market or a country that can bring more of the good in from the outside; that is, it can import. Alternatively, this same market or country can sell more of its goods to the outside world; that is, it can export. In this case, rather than determining an equilibrium price and quantity, we'll be determining an equilibrium volume of international trade, imports or exports. Now, we're going to be using the same tools that we used before, with one modification. Let's look at it.
The demand curve this time represents the demand of all of those people who live within the market or the country. To make this more concrete, let's suppose we're talking about a country like France and product like this one. This is a pomelo, the world's largest citrus fruit. Now, there are not a lot of these that are actually grown in France, because the climate isn't suitable and it would be very expensive, a large opportunity cost, for the French to give up the other goods that they would have to give up to make these pomelos. So the pomelo is imported. On this curve, we're representing the demand of people in France for pomelos. At each price, there is a quantity that the people in France will want to buy of the pomelo, given their income, the price of substitutes, the price of complements, expectations and all of those other factors that influence demand.
Let's look now at the supply curve. This is the supply curve for pomelos in France; that is, the domestic supply curve. This curve tells you, at each price per pomelos, how many of them are actually produced by farmers in France itself. This supply curve refers to the supply of pomelos domestically. So I'll go ahead and put a little sub-d in my diagram to remind me that this is the supply of domestic farmers. The demand curve is the demand for pomelos domestically, so I'll put a little d here to remind me that these are the people in the market itself, in France, who want to buy different quantities of pomelos at different prices. Now, if this were a closed economy, the price of the pomelo would be determined where the supply curve and the demand curve meet; that is, there is only one price at which the quantity supplied and the quantity demanded are equal. There is one price at which we have an equilibrium. And the quantity demanded of pomelos is on the quantity axis below that intersection. But this is going to be a different story. Rather than considering the closed economy, we're going to consider an open economy. And we represent the open economy by inserting a world price line. The world price line reminds us that, as far as pomelos are concerned, France is a small country. That means that the farmers in France can produce as many pomelos as they're capable of without producing so many that they actually affect the world price. People in France can buy all the pomelos that they might be inclined to buy, also without influencing the world price. Most of the pomelos in the world are grown outside of France and most of them are consumed outside of France. So as far as this particular fruit is concerned, France is a small country, a country without influence on the world price. So we can put the world price in our diagram and it's going to be a constant. No matter how many pomelos are supplied and demanded in France, there will be no effect on the world price. Let's put the line in.
Suppose the world price for pomelos is right here, P[W]. This is the world price and we might imagine that it's a dollar per pomelo; that is, you can buy or sell all the pomelos you want to on the world market for a dollar apiece. So I'm going to let this line go across the diagram. It represents the opportunity for international trade. It represents the opportunity to buy and sell outside of France, in the rest of the world, at the price of 1 dollar per pomelo. Now, with a world price given at a dollar, people in France are always going to have the opportunity to buy pomelos for a dollar apiece from someone outside of France. They might import them from Spain or Africa or somewhere else. Any farmer who produces pomelos in France has to compete with these imports; that is, they have to compete with farmers other places, who are able to produce and sell pomelos for a dollar. That is, no one will pay more than a dollar, because of the alternative to import the good, and no farmer can charge more than a dollar, because otherwise he or she would be undercut by competition. So what happens in this market? The world price is fixed. France is a small country and it takes this world price as given. What then do the people of France do? Well, let's look at our supply and demand curves, which represent the behavior of people in this market.
On the blue curve, we can see what the French farmers are going to do when the price of pomelos is set at a dollar per fruit; that is, they can cover the opportunity cost of producing only a few pomelos before the opportunity cost rises to the point where it's no longer profitable for them to make the fruit. The quantity supplied domestically will be given by this intersection. This intersection tells us the quantity that the French farmers can afford to supply. So we'll use a QSD to represent the domestic quantity supplied. Going over to the demand curve, we see how many pomelos French customers want to buy at a price of a dollar each. This is the quantity that people in France are willing and able to purchase at the price P[W], maybe a dollar per pomelo. Notice that the quantity demanded is a much larger quantity than the quantity supplied. The quantity demanded domestically is very large, because French people find the pomelos to be a bargain and are very happy to buy a lot of them. Now, here's where international trade is different than the closed economy.
In the closed economy, you couldn't have a situation where the quantity demanded is greater than the quantity supplied. Remember we called that excess demand. And when excess demand is present, the bidding mechanism pushes up the price of the good, until we return to equilibrium. In this case, however, we imagine that, because international trade is possible, the quantity demanded domestically can be larger than the quantity supplied domestically. It's possible for people in France to eat more pomelos than French farmers produce. How do they do it? They import the difference between the domestic demand and the domestic supply. The difference between these two points represents the quantity of pomelos that are imported in equilibrium.
In the international trade equilibrium, we don't determine the price. The price is given from outside. What we do determine is the difference between the quantity supplied domestically and the quantity demanded domestically; that is, the volume of imports. And the volume of imports will depend on domestic supply, domestic demand and the world price.
So, to summarize, with international trade, instead of finding the place where the curves intersect, you put in the world price line and find the difference between the quantity supplied domestically and the quantity demanded domestically. This is our equilibrium.
International Focus
Microeconomics Background
Determining the Difference Between a Closed Economy and an Open Economy Page [2 of 2]

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