Assuming that external economies exist, when demand increases in a perfectly competitive market, in the long-run, the price of the product
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GATE 2021 Question 15: Perfect competition
Answer and worked solution
Answer: (C)
In the standard (constant-cost) long-run competitive model, the long-run supply curve is horizontal, and a demand increase raises quantity while price returns to its original level.
However, with external economies of scale — where individual firms' costs fall as the industry as a whole expands (e.g., from better-developed supplier networks, shared infrastructure, or knowledge spillovers that come with industry growth) — the long-run industry supply curve is downward-sloping, not horizontal.
When demand increases in this case, the new long-run equilibrium occurs at a higher quantity and a LOWER price than the original equilibrium, because the very expansion of the industry (driven by the higher demand) triggers the cost-reducing external economies, pulling the long-run price down below its original level.
Therefore the answer is (C): the price falls below the initial price, and quantity increases.
The trap: (B) remains the same as the initial price (before the demand increase) and quantity increases
Students who default to the more commonly-taught constant-cost industry case (long-run supply perfectly horizontal, price unchanged after a demand shift) may pick (B) without registering that the question specifically stipulates 'external economies exist,' which changes the standard result entirely — this is a less commonly emphasized case (decreasing-cost industry) that requires noticing the qualifier in the question.
Perfect competition has come up 115 times in 7 exams since 2006.
What this question tests
This question is on Long-run equilibrium, entry and exit, part of Perfect competition in Microeconomics.
Why free entry drives profit to zero in the long run, and what that implies for the number of firms and industry supply.
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Question from the GATE 2021 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.