Question

Please explain how to calculate Total Social Welfare (total surplus) with and without the presence of an excise tax, without the use of imagery.

Answer 1

Total surplus is the area between the demand and supply curves that extends from y-axis to the right till equilibrium quantity. This area spreads out on the canvas of the first quandrant, where both axes are positive. The area of total surplus is normally a tringle. Y intercept of the demand curve is the highest willingness to pay of consumers. Y intercept of demand curve is the minimum reservation prce of producers. The y intercept of demand curve and y- intercept of supply curve are the two points of the triangle The third point of the triangle is the intersection of demand and supply curve that also determines the equilibrium quantity and price. The triagular area of total surplus consists of consumer surplus and producer surplus. Consumer surplus lies below the demand curve and above the price line. Producer surplus lies above the supply curve and below the price line.

When excise tax is imposed, it creates a wedge between the price paid by consumers and the price received by producers. That wedge is the tax revenue. In other words, tax revenue is deducted from the price paid by consumers and the balance is the price received by producers (Ps = Pb - T). Two more components are added when an excise tax is imposed: (a) tax revenue, and (b) deadweight loss. Tax revenue goes to the government. Deadweight loss is the lost surplus. It is wasted. It is the result of shiifting of the supply curve. When tax is levied, the supply curve shifts inward by the amount of the tax. Due to this shift, quantity produced decreases. Deadweight loss is the area of this lost quantity and the tax amount. DWL = ½*tax amount * lost quantity. Total surplus thus reduces when tax is levied.