Gains from trade: Demand, supply, and idiosyncratic shocks

Summary 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.