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ProfitWell MetricsBusinesses need to know how changes in their product prices affect their income. Therefore, before you decide to either lower or raise your prices to increase sales (and total revenue), you should first determine the price change effect using a total revenue test.
The test will help your business determine what type of demand exists for your products or services, allowing you to set the optimum price to achieve maximum revenue.
This post looks at the total revenue test and how to use it to determine your product's price elasticity of demand.
What is a total revenue test?
It's a test that determines whether a product's (or service's) demand is elastic or inelastic. The test approximates a product's price elasticity of demand by measuring the change in the total revenue against a change in the price. From this total revenue test definition, it's correct to say that it only considers price and assumes all other relevant factors (that could influence revenue) remain constant.
What are the advantages of the total revenue test?
The total revenue test can help a business in its pricing strategy. Using the test, you can determine the extent of a product or service's elasticity or inelasticity. Price elasticity is the extent to which a product's (or service's) price affects consumer demand.
If a price increase also increases the total revenue for the period, then the product's demand is inelastic—the price increase has little impact on the quantity demanded. Here, the business can increase its products' prices to increase total revenue.
On the other hand, if the price increment causes a decrease in total revenue, the demand is elastic since the price change significantly impacted the quantity demanded. Therefore, the business should be cautious about its price changes.
Using total revenue test to determine the price elasticity of demand
As stated above, the total revenue test for elasticity assumes that price is the only factor affecting demand. To conduct the test, follow the following two simple tests and observe the results.
1. Step one: Hypothesize
Hypothesize what will happen when you increase or decrease the price of your product or service. You will begin your test based on this hypothesis using the past data you have collected and observed. For example, let's say you decide to raise your product's price by 12% because you believe it will increase your total revenue moving forward.
2. Step two: Execute
Identify a test period, say three months (one quarter of your financial year), and raise your price by 12%. Then, observe the effect of your new price on the total demand for that period and measure your sales revenue.
- If the new price results in a dramatic drop in total revenue, then the product has an elastic demand, and you must be careful about your pricing strategy moving forward
- If the revenue drops by an equivalent percentage as the price increment, the product has unitary elasticity
- If demand does not fall despite the price increase, the product is perfectly inelastic. You can try raising your price further to see at what point demand falls off
The total revenue test has a limit because, despite a product's demand elasticity or inelasticity, demand for all products eventually drops off over time. Therefore, it means that your results may at best produce results that hold for a limited time.
Total revenue test formula
To calculate total revenue (TR), multiply the price per unit (P) and quantity of the product sold (Q).
- TR = P × Q
You can use the total revenue test to estimate a product's price elasticity of demand. Since the elasticity of demand affects the total revenue, you can estimate it by observing the latter's movement.
Total revenue test graph: visual explanation
First, represent total revenue on a graph by plotting the quantity demanded on the X-axis and price on the Y-axis. Next, plot two points on the graph with:
- Point A representing the total revenue from your original product price and the quantity demanded
- Point B representing the total revenue from the new product price and resultant quantity demanded
Then plot a demand curve passing through the two points.
To identify the price elasticity of demand for your product from the total revenue test graph, draw the following two rectangles:
- Plot two lines from point A to point P1 on the Y-axis intercept and Q1 on the y-Axis intercept
- Plot two lines from point B to point P2 on the Y-axis intercept and Q2 on the y-Axis intercept
The rectangle P1 P2CA represents the price effect and refers to a revenue change due to a price change. The rectangle Q1Q2BC represents the quantity effect and relates to revenue change due to quantity change.
- If the rectangle area representing the price effect is greater than that representing the quantity effect, demand is inelastic (Ed<1)
- Similarly, if the reverse is true, the product's demand is elastic (Ed>1)
- If the price effect is similar to the quantity effect, then demand is unit or unitary elastic
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Total revenue test FAQs
Can you use the total revenue test on supply?
No, you cannot use the total revenue test to test for price elasticity of supply. The reason is that total revenue and price always move in one direction, regardless of the price elasticity of supply degree.
What does total revenue indicate?
Total revenue indicates the full amount of sales of a company's goods or services. To calculate total revenue (TR), multiply the total amount of goods or services sold (Q) by price (P).
What is the total revenue test's impact on the business?
The total revenue test can help a business with its pricing strategy. Using the test, you can determine the extent of a product or service's elasticity or inelasticity and use that information to set optimal prices for maximum revenue.
