Final answer:
The imposition of a fixed annual fee on firms in a competitive market with free entry leads to an increase in the firms' average total cost, potentially altering the long-run industry equilibrium by causing firm exit, increased optimal scale for remaining firms, and higher prices.
Step-by-step explanation:
When the government imposes a fixed fee on each firm in a competitive market with free entry, the initial effect is an increase in the firms' cost structures. This fee represents an additional fixed cost that each firm must pay regardless of its output level. In the short run, firms that can cover their variable costs plus the fee will continue to operate, while those that cannot will shut down. As an added fixed cost, the fee does not affect the marginal cost (MC), which determines the quantity of output at which the firm maximizes profit in the short run. Therefore, the output level per firm might not change immediately.
In the long run, however, the dynamics are different. The higher cost due to the fee will lead to a higher average total cost (ATC) for each quantity of output. The industry supply curve will shift upwards, leading to a higher market price. As the market adjusts to a new equilibrium, some firms might find it unprofitable to operate and will exit the market. This exit of firms will reduce the total output in the industry and can lead to a greater optimal scale for the remaining firms as they may expand to fill the demand previously covered by the exited firms.
The Firm and Industry Diagrams:
On the firm-level diagram, the ATC curve would shift upwards due to the fixed fee. The new breakeven point where the MC intersects the ATC will be at a higher quantity, suggesting a larger optimal scale for the remaining firms. On the industry-level diagram, the supply curve shifts up, resulting in a higher price and reduced total output.