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.