Economists use the term elasticity of demand to describe the way people respond to price changes. If you keep buying despite a price increase, your demand is inelastic. If you buy less after a small price increase your demand is elastic. Demand tends to be inelastic for goods that have few substitutes, like medicines, or for goods that are considered essential, like milk.
To compute elasticity of demand, take the percentage change in the demand of a good and divide this number by the percentage change in the price of the good. Say that if the price of pizza rises from $1.00 to $1.50, demand falls from 4 to 3 slices per day. The change in demand is a 25 percent decrease. The change in price is a 50 percent increase. The elasticity of demand is 25 percent divided by 50 percent, or .5. Since this number is less than 1, the demand is inelastic—customers continue to buy even if the price increases. A demand that is more than 1 is elastic.
Elasticity is an important tool for business owners. It helps them to determine how a change in prices will affect their business’s total revenue, or the amount of money the company receives by selling its goods. If a business faces elastic demand, then raising prices will result in a sharp drop in demand, decreasing total revenue. However, when a good has an inelastic demand, a business might be able to increase its total revenue by increasing the price.