Let’s begin looking at the puzzle of oligopoly with the simplest version, an industry in which there are only two producing firms—a duopoly—and each is known as a duopolist.

Going back to our opening story, imagine that ADM and Ajinomoto are the only two producers of lysine. To make things even simpler, suppose that once a company has incurred the fixed cost needed to produce lysine, the marginal cost of producing another pound is zero. So the companies are concerned only with the revenue they receive from sales.

Table 14-2 shows a hypothetical demand schedule for lysine and the total revenue of the industry at each price-quantity combination.

If this were a perfectly competitive industry, each firm would have an incentive to produce more as long as the market price was above marginal cost. Since the marginal cost is assumed to be zero, this would mean that at equilibrium lysine would be provided free. Firms would produce until price equals zero, yielding a total output of 120 million pounds and zero revenue for both firms.

However, surely the firms would not be that stupid. With only two firms in the industry, each would realize that by producing more, it drives down the market price. So each firm would, like a monopolist, realize that profits would be higher if it and its rival limited their production.

So how much will the two firms produce?

One possibility is that the two companies will engage in collusion—they will cooperate to raise their joint profits. The strongest form of collusion is a cartel, an arrangement between producers that determines how much each is allowed to produce. The world’s most famous cartel is the Organization of Petroleum Exporting Countries (OPEC), described in an Economics in Action later in the chapter.

As its name indicates, OPEC is actually an agreement among governments rather than firms. There’s a reason this most famous of cartels is an agreement among governments: cartels among firms are illegal in the United States and many other jurisdictions. But let’s ignore the law for a moment (which is, of course, what ADM and Ajinomoto did in real life—to their own detriment).

So suppose that ADM and Ajinomoto were to form a cartel and that this cartel decided to act as if it were a monopolist, maximizing total industry profits. It’s obvious from Table 14-2 that in order to maximize the combined profits of the firms, this cartel should set total industry output at 60 million pounds of lysine, which would sell at a price of $6 per pound, leading to revenue of $360 million, the maximum possible.

Then the only question would be how much of that 60 million pounds each firm gets to produce. A “fair” solution might be for each firm to produce 30 million pounds with revenues for each firm of $180 million.

But even if the two firms agreed on such a deal, they might have a problem: each of the firms would have an incentive to break its word and produce more than the agreed-upon quantity.