Central to any pricing decision is understanding how customers respond to price changes. Price elasticity of demand measures the percentage change in quantity demanded for each percentage change in price, given by \( Price\ Elasticity = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Price} \). If a small price change triggers a proportionally larger change in quantity, demand is elastic (elasticity magnitude greater than 1), and lowering the price increases total revenue. If a price change produces a proportionally smaller change in quantity, demand is inelastic (elasticity magnitude less than 1), and raising the price increases total revenue. When the percentages move one-to-one, demand is unit elastic (elasticity equals 1) and revenue is roughly insensitive to price changes, reaching its maximum at the unit-elastic point.
Demand becomes more elastic when buyers have many substitutes, when the purchase represents a large share of their budget, when the good is non-essential, when the time horizon is long, or when the market is defined narrowly. Demand becomes more inelastic when there are few or no substitutes, when the item is a small share of the budget or a necessity, when the time horizon is short, and when there is strong brand loyalty or addiction. Two related measures extend this idea across products and over time. Cross-price elasticity is the percentage change in quantity demanded of one good divided by the percentage change in price of another; a positive value indicates substitutes (demand for one rises when the other's price rises), and a negative value indicates complements. Income elasticity is the percentage change in quantity demanded divided by the percentage change in consumer income; a positive value marks a normal good whose demand rises with income, while a negative value marks an inferior good whose demand falls as income rises.
Two unusual cases stretch the standard picture of downward-sloping demand. A Veblen good is a luxury whose demand actually increases as its price increases, because a high price signals status or conspicuous value. A Giffen good is the rare case of an inferior good with no close substitutes where demand rises as price rises, contrary to typical theory. The law of demand, however, remains the baseline expectation: holding everything else constant, when price rises, quantity demanded falls, and vice versa. The demand curve graphs this relationship, the supply curve graphs how much producers will offer at each price, and the market-clearing or equilibrium price is the level at which quantity supplied equals quantity demanded. When demand exceeds supply, price tends to rise; when supply exceeds demand, price tends to fall.