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A General Equilibrium Model of the Oil Market

We present a general equilibrium model of the global oil market, in which the oil price, oil production, and consumption, are jointly determined as outcomes of the optimizing decisions of oil importers and oil exporters. On the supply side the oil market is modelled as a dominant firm – Saudi Aramco – with competitive fringe. We establish that a dominant firm may exist as long as it enjoys a cost advantage over the fringe. We provide an expression for the optimal markup and compute the spare capacity maintained by such a firm. The model produces plausible dynamics in response to oil supply and oil demand shocks. In particular, it reproduces successfully the jump in oil output of Saudi Aramco following the output collapse of Iraq and Kuwait during the first Gulf War, explaining it as the profit-maximizing response of the dominant firm. Oil taxes and subsidies affect the oil price and welfare through their effect on the trade-off between oil production efficiency and oil market competition.