What is the total revenue test? How does it work in terms of a calculation?

Answer:
Total revenue is equal to price x quantity sold. We can determine the relationship between total revenue and elasticity from a price cut in this way.

1. If a price cut leads to an increase in total revenue, then the demand for a good or service is price elastic.
2. If a price cut leads to a decrease in total revenue, then the demand for a good or service is price inelastic.
3. If, after a price cut, total revenue stays the same, then the demand for a good or service is said to be unit elastic.

Here is a good calculation question to test your knowledge of elasticity and total revenue.

Dave's CD Shop finds that last year it sold 10,000 Janet Jackson CDs, and 10,000 Rolling Stones CDs, each at $5 per disc. Manager David believes that Dave's CD Shop would be better off raising the price of both CDs to $6. The elasticity of demand for the Jackson CD is 2.0, and is 0.5 for the Stones.

Can you use the elasticity formula to advise David? Is it right to raise the price of both CDs?

Answer:

Janet Jackson CD

1. 2.0 = x over 20% = 40% reduction in sales
2. 10,000 units sold x 40% = 4,000 fewer sales
3. 10,000 minus 4,000 = 6,000 sold
4. 6,000 x $6 = $36,000 in sales.

The Stones CD

1. 0.5 = x over 20% = 10% reduction in sales
2. 10,000 units sold x 10% = 1,000 fewer sales
3. 10,000 minus 1,000 = 9,000
4. 9,000 sold x $6 = $54,000 in sales.

Advice to Dave: Raise the price on the Rolling Stones CD (make an extra $4,000), but leave the price of the Janet Jackson CD alone (otherwise, lose $14,000).