What Is a Total Revenue Test?
A total revenue test approximates the price elasticity of demand by measuring the change in total revenue from a change in the price of a product or service. Price elasticity refers to the extent to which the price of a product or service affects consumer demand for it; when the price affects demand, the price is said to be elastic, but when it does not or does not to a lesser degree, it is said to be inelastic. The total revenue test assumes all other factors that may influence revenue will remain constant during the testing period.
How a Total Revenue Test Works
The total revenue test can assist a company in its pricing strategy. By determining the extent to which a product is elastic or inelastic, the firm would have better insight into how to maximize total revenue, especially if it sells a range of products. If the test concludes that demand for a product is very elastic, the company will be very cautious about price changes, as small changes could produce large decreases in demand and therefore total revenue.
Alternatively, if demand is relatively inelastic, the firm will believe that increases in price will only yield small changes in the quantity demanded. Therefore, an increase in price will be less likely to spur a large decrease in demand if demand is very inelastic. In fact, an increase in price would be more likely to lead to an increase in total revenue, because an inelastic demand indicates that price is not one of the most important factors influencing consumer demand for the product.
Example of a Total Revenue Test
An athletic apparel company makes three types of yoga pants called Downward Dog, Warrior, and Cobra that cost $50, $60, and $70, respectively. The company sells 1,000 pairs of Downward Dog each month, 800 pairs of Warrior, and 500 pairs of Cobra at those prices. The yoga pants generate a monthly revenue of $133,000. The company conducts a total revenue test. It raises the price of Downward Dog to $55, raises the price of Warrior to $63, and lowers the price of Cobra to $67. Sales of Downward Dog drop to 700 pairs, while Warrior sales decline marginally to 770, and Cobra sales increase to 600. Downward Dog revenue declines to $38,500 from $50,000 before the price change.
Demand is considered elastic for Downward Dog because the increase in price significantly affected demand for the product and led to a drop in revenue. By contrast, the company gained $510 in Warrior revenue ($48,510, the new price x quantity, versus $48,000 before the price change), suggesting demand inelasticity from the $3 increase in price. The company further determined from the total revenue test that consumers responded favorably to the discounting of Cobra pants. Cobra produced $40,200 in monthly revenue, versus $35,000 previously. However, combined revenue was $127,210, compared to $133,000 prior to the price changes. The company can conduct more iterations of the total revenue test to formulate a pricing strategy to surpass $133,000.