What it means
Price elasticity of demand measures how much the quantity sold changes when the price changes. If customers are very sensitive to price, demand is elastic, and if they are not, demand is inelastic, and this affects whether a price change helps or hurts revenue.
The total revenue test avoids the need to calculate elasticity directly. It simply looks at the direction in which price and total revenue move.
If price and total revenue move in opposite directions, demand is elastic, and if they move in the same direction, demand is inelastic. The logic is easy to follow.
When demand is elastic, a price rise loses so many customers that revenue falls, and a price cut brings in so many extra customers that revenue rises. When demand is inelastic, customers stay loyal, so a price rise lifts revenue and a price cut reduces it.
If revenue does not change when the price changes, demand is unit elastic, meaning the percentage change in quantity exactly offsets the percentage change in price. This is the point at which revenue is at its highest for a straight-line demand curve.
Businesses use the test for pricing decisions on subscriptions, tickets, fuel, groceries, software licences and so on. It is also useful in public policy, for example when a government considers a tax on a product and wants to know whether sales will fall sharply.
The test has limits. It measures revenue and not profit, so a price rise that lowers revenue may still raise profit if costs fall by more, and elasticity can differ at different price levels, so the result applies only to the range tested.
In practice
Real-world examples.
Example
A streaming service raises its price from $8 to $9 a month and its subscribers fall from 500,000 to 440,000. Revenue drops from $4,000,000 to $3,960,000, so the service concludes demand is elastic and holds the price.
Example
A pharmacy raises the price of a necessary prescription item from $20 to $22, and unit sales fall by only 3%. Revenue rises, so demand is inelastic, and the manager is comfortable with the increase.
Example
A cinema cuts the price of weekday tickets from $12 to $9 and sales rise from 600 to 900 tickets. Revenue goes from $7,200 to $8,100, so the price cut worked because demand was elastic.
Formula
Calculation
Total revenue = Price x Quantity sold
Rule: if price and total revenue move in opposite directions, demand is elastic; if they move in the same direction, demand is inelastic; if revenue is unchanged, demand is unit elastic.
Suppose a gym raises its monthly membership from $10 to $12, and the number of members falls from 1,000 to 800. Revenue before = 10 x 1,000 = $10,000, and revenue after = 12 x 800 = $9,600. The price rose and revenue fell, so demand is elastic in this range. Had members fallen only to 950, revenue would have been 12 x 950 = $11,400, higher than before, which would show inelastic demand.Case study
Seen in the real world.
Harbourview Parking is an illustrative, fictional operator of a car park near a train station. It charged $10 a day and filled an average of 400 spaces, giving daily revenue of $4,000, and management considered a price rise to $12.
A trial at one of its smaller sites raised the price to $12 and the occupancy fell from 100 to 92 spaces. Revenue changed from 10 x 100 = $1,000 to 12 x 92 = $1,104, so price and revenue moved in the same direction and demand was inelastic.
The company rolled out the increase across its sites and watched occupancy closely. The illustrative result confirmed the test, although managers noted that a further rise might eventually push commuters towards the train station's own car park, where demand would become elastic.
Watch out
Common mistakes.
- Assuming that a price rise always increases revenue, when with elastic demand it can lower revenue.
- Treating the result as permanent, when elasticity changes with the price level, the time period and competitors' actions.
- Using the test to decide on profit, when a business should also consider the cost of producing each extra unit.
Questions
People also ask.
What does it mean if total revenue falls after a price cut?
It means demand is inelastic, because the extra units sold are not enough to make up for the lower price on every unit.
Is the total revenue test accurate?
It gives a reliable direction for a given price range, but it cannot say how elastic demand is, and other factors that change at the same time, such as advertising or the season, can confuse the result.
When is demand likely to be inelastic?
Typically for necessities, products with few substitutes and purchases that are a small part of a budget.
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