This study attempts to explain why crude oil prices fluctuate, the main cause being the quota regime, which characterises the OPEC agreements. Given that the Saudi oil supply is inelastic in the short term, a shock in the oil market is accommodated by an immediate price change. By contrast, a dominant firm behaviour in the long term causes an output change, which is accompanied by a smaller price change. This explains why oil prices overshoot. The results of a general equilibrium model applied to Saudi Arabia support this analysis. They also indicate that Saudi Arabia does not have any incentive for altering the crude oil market equilibrium with either positive or negative supply shocks, as its welfare declines; and that it has an incentive (disincentive) for intervening if a negative (positive) demand shock hits the crude oil market. A second set of simulations is designed to understand what kind of OECD policy might help to bring down prices. A tax cut would worsen the situation, whereas policies that can increase the price elasticity of demand seem to be very effective. (C) 2002 Elsevier Science B.V. All rights reserved.
