A total revenue test is a method of estimating the price elasticity of demand. It helps to determine how the price of a product influences consumer willingness to buy it.
Total revenue and the price elasticity of demand have an interconnected relationship. Therefore, a reasonably easy way to determine the elasticity or inelasticity of demand is to estimate the total revenue indicator, showing what happens to the total revenue when the product price changes.
Economics considers the index as a crucial one as it provides firms with the opportunity to estimate their elasticity that is important in the process of turning the effect of price changes in their favor.
Elastic demand is when lower prices lead to higher total revenues. In this case, even at a lower unit price, the increase in sales (measured in units of the product) is more than sufficient to compensate for the losses from the price reduction. Thus, if demand is elastic, a change in price causes a change in total revenue in the opposite direction.
For instance, a 10% price decrease may lead to expanding demand by 35% (price elasticity of demand = +3.5%). If inelastic demand takes place, a lower price leads to a decline in overall profit. A small expansion of sales, which will occur in this case, will not be sufficient to compensate for the decrease in revenue received per unit of output so that ultimately the total revenue will decrease. For example, a 40% fall in price can lead to expanding demand by 10% (price elasticity of demand = -0.25%).
In the particular case of perfect inelasticity, an increase or decrease in price will leave total revenue unchanged. Loss of income due to lower unit prices will be exactly offset by concomitant sales expansion. Conversely, revenue growth resulting from unit price increases will be exactly offset by revenue loss caused by a concomitant reduction in the number of products requested.
Thus, if demand is perfectly inelastic, “a given price change will result in the same revenue change, e.g. a 5 % increase in a firm’s prices results in a 5 % increase in its total revenue.” It should be mentioned that perfect inelasticity is the rarest case of demand elasticity.
The example of how the total revenue test is used may be as follows. A company makes two types of jackets called Snake and Tiger that cost $30 and $40, respectively. The firm sells 1000 Snakes and 800 Tigers at those prices; the jackets provide a monthly revenue of $62,000. The corporation decides to conduct a total revenue test. It raises the price of Snake to $37 and the cost of Tiger to $45. Sales of Snake are now 600 pairs, while Tiger sales are 770.
Profit from Snake declines to $22,200 from $30,000 before changing the price. Demand is elastic for Snake as the higher price sustainably influenced the demand for the product and caused a drop in profit. By contrast, the firm earned $2650 from Tiger sales (the new income is $34,650 while it was $32,000 before the price change).
It might be concluded that demand is inelastic as the $5 increase in price has not considerably impacted demand. Referring to the given results, the company now can develop its new business strategy to surpass a revenue of $62,000, making an accent on Tigers supply.