Gains from trade: Demand, supply, and idiosyncratic shocks

Firm-level sales are often used as a proxy for productivity to quantify welfare gains from trade (GFT) using firm-level data. This approach ignores the fact that heterogeneity in firm-level sales is driven by factors other than productivity. Our theoretical and empirical analysis reveals that using sales as a proxy conflates persistent productivity with transitory demand and supply shocks, resulting in an over-dispersed productivity distribution. Assigning this shock-inflated productivity to a modeled economy's supply-side results in overestimated GFT. We show how to obtain unbiased productivity estimates, aggregate trade elasticities, and GFT estimates by exploiting the revenue production function from a single-source country.