The impact of windfalls: Firm selection, trade and welfare

We ask how a small open economy with heterogeneous firms responds to a resource windfall. A resource windfall boosts demand but also affects wages such that production costs increase. The result is a higher number of firms and renewed selection among firms: New firms at the lower end of the productivity continuum can produce for the domestic market, while only the most productive firms continue to export. While the share of firms that sell traded varieties decreases, the average productivity of exporting firms increases. The increase in the number of varieties caused by a larger number of firms and the inflow of additional imports implies that there is an increase in aggregate welfare over and above the direct windfall gain. We provide analysis in a model with two types of labor. The windfall causes a reallocation of labor types and a change in relative wages, thereby implying different welfare outcomes for each type of labor and the possibility of rising inequality.