Let us say you have opened a coffee shop and find you are losing money after your first year in business. The problem seems to be in the pricing. If you raise prices, you will make more money on each cup of coffee that is sold. The problem with this approach is that the law of demand states that less of a product will be demanded at a higher price.
If you lower prices, the law of demand states that you will sell more coffee but will not make as much on each cup sold. Should you raise prices or should you lower prices?
What you really need to know is how much the quantity demanded will change when the price changes. If you raise prices and only lose a little business, then you will likely make more money. If prices are raised and a lot of business is lost, then you will most likely make less money.
The way an economist determines the sensitivity of quantity demanded to a change in price is called the price elasticity of demand. The price elasticity of demand lets us know the percentage change we could expect in the quantity demanded for a 1% change in price. The formula for the price elasticity of demand is:
price elasticity of demand = (% change in quantity demanded) / (% change in price)
Note that the law of demand implies that the price elasticity of demand is always negative, since a positive change in price implies a negative change in quantity demanded and vice versa. Since the sign is always negative, we ignore it and treat the price elasticity as a positive number.
We can then assess the result of our calculation using the following definitions:
if the result is > 1, demand is said to be elastic
if the result is < 1, demand is said to be inelastic
if the result is = 1, demand is said to be unitary elastic
When demand is elastic, the price change has caused a (relatively) large change in quantity; when it is inelastic, the quantity change in percentage terms is smaller than the price change that caused it. And when demand has unitary elasticity, the percentage change in quantity demanded is exactly equal to the percentage change in price.