What is the relationship between price elasticity of demand and total revenue quizlet?

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.

Price inelasticity is very beneficial for businesses and is important in understanding how they should formulate their pricing strategy. Price inelasticity offers firms greater flexibility with prices as the change in demand remains essentially the same whether prices increase or decrease. If the price goes up or down, you can expect consumers’ buying habits to stay mostly unchanged.

How Price Inelasticity Affects Demand

For price inelastic goods or services, the change in the amount demanded is minimal with respect to the change in price.

This can affect demand and total revenue for a business in two ways.

Less Overall Revenue

If the price for an inelastic good is lowered, the demand for that good does not increase, resulting in less overall revenue due to the lower price and no change in demand. This would indicate that the firm should not reduce the price of its goods as there is no beneficial outcome in doing so.

More Overall Revenue

On the other hand, if the price for an inelastic good is increased and the demand does not change, the total revenue increases due to the higher price and static quantity demanded. However, price increases typically do lead to a small decrease in quantity demanded.

This means that firms that deal in inelastic goods or services can increase prices, selling a little less but making higher revenues. Therefore, businesses that deal in goods that are price inelastic are better equipped for profit maximization and are better protected against economic downturns.

Price inelasticity shows that customers—and by extension, demand—are more tolerant to price changes. Therefore, firms that deal in inelastic goods or services can transfer the extra cost of production to their customers without adversely affecting the demand. As a result, price inelasticity offers better flexibility at setting up or establishing pricing strategies.

When Does Price Inelasticity Typically Happen?

The main factors that determine demand are price, price of substitutes, income, taste, and expectations of future price changes. Other minor factors do come into play, such as brand loyalty.

Price inelasticity usually occurs with products that have fewer close substitutes, which means fewer options for customers. Such goods tend to be necessities that people can't do without and therefore their needs stay the same. Examples of inelastic goods include basic food, gasoline, important medicine, such as insulin, and habitual goods, such as tobacco products.

To enhance pricing flexibility and profit maximization, firms can strive to create or deal in more customized or distinctive goods or services where there are few close substitutes as sophisticated brands possess greater inelasticity. Though luxury items are typically price-elastic, many companies that sell distinct luxury goods that are unique might experience some inelasticity.

An example would be Apple's iPhone. Slight increases in the price would not adversely affect the demand for the phone. On the other hand, firms that deal in more ordinary products typically need to reduce prices and sell at competitive rates to gain an edge over competing brands.

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