What it is:
Something is elastic when its price varies with the price of another item. It the business world, the term most often refers to how much the price of a good or service changes when the supply of that good or service changes.
The formula for elasticity is:
Elasticity = % Change in Quantity/% Change in Price
How it works/Example:
Let's assume that when gas prices increase by 50%, gas purchases fall by 25%. Using the formula above, we can calculate that the price elasticity of gasoline is:
Elasticity = -25%/50% = -0.50
Thus, we can say that for every percentage point that gas prices increase, gas purchases decrease by half a percentage point. The price of gas is elastic.
Why it matters:
If demand changes a lot when prices change a little, the demand for a product is elastic. This often is the case for products or services for which there are many alternatives or for which consumers are price sensitive.
The opposite is also true: When there is a small change in demand when prices change a lot, the product is inelastic. This is often the case for products and services that people consider necessities and purchase at almost any price. The presence of few good substitutes and the presence of customer loyalty are also factors. At some point, however, there is a price at which demand for any good or service fall to zero or near zero.