What is Price Skimming?

Price skimming, also known as skim pricing, is a pricing strategy in

which a firm charges a high initial price and then gradually lowers the
price to attract more price-sensitive customers. The pricing strategy is
usually used by a first mover who faces little to no competition. Price
skimming is not a viable long-term pricing strategy, as competitors
eventually launch rival products and put pricing pressure on the first
company.

Rationale Behind Price Skimming

Price skimming is used to maximize profits when a new product or

service is deployed. Therefore, the pricing strategy is largely effective
with a breakthrough product, where the firm is the first to enter the
marketplace. In such a strategy, the goal is to generate the maximum
profit in the shortest time possible, rather than to generate maximum
sales. This enables a firm to quickly recover its sunk costs before
increased competition and pricing pressure arise.

Consider the diffusion of innovation, a theory that explains the rate at

which a product spreads throughout a social system. Innovators are
those who want to be the first to get a new product or service. They are
risk-takers and price insensitive. A price skimming strategy tries to get
the highest possible profit from innovators and early adopters. As the
demand from these two consumer segments fills up, the price of the
product is reduced, to target more price-sensitive customers such as
early majorities and late majorities.
Illustration and Example of Price Skimming

Company A is a phone manufacturing company that recently developed

a new proprietary technology for its phones. Company A follows a price
skimming strategy and sets a skim price at P1 to recover its research
and development cost. After satisfying demand at P1, the company sets
a follow-on price at P2 to capture price-sensitive customers and to put
pricing pressure on competitors that enter the market.
In the price skimming strategy above, Company A generates revenue =
A + B with sales of Q1. With their follow-on pricing, the company
generates additional revenue = C with sales of Q2-Q1. The company
generates total revenue of A + B + C, with total sales of Q2.

Advantages of Price Skimming

 Perceived quality: Price skimming helps build a high-quality

image and perception of the product.
 Cost recuperation: It helps a firm quickly recover its costs of
development.
 High profitability: It generates a high profit margin for the
company.
 Vertical supply chain benefits: It helps distributors earn a
higher percentage. The markup on a $500 product is far more
substantial than on a $5 item.

Disadvantages

 Deterrence: If the firm is unable to justify its high price, then

consumers may not be willing to purchase the product.
 Limitation of sales volume: A firm may not be able to
utilize economies of scale if a skim price generates too few sales.
 Inefficient long-term strategy: Price skimming is not a viable
long-term pricing strategy, as competitors will eventually enter
 the market with rival products and exert downward pricing
pressure.
 Consumer loyalty: If a product that costs $1,000 at launch has a
follow-on price of $200 in a couple of months, innovators and
early adopters may feel ripped off. Therefore, if the firm has a
history of price skimming, consumers may wait a couple of
months before purchasing the product.

 What Is Price Skimming?

 Price skimming is a product pricing strategy by which a firm charges the
highest initial price that customers will pay and then lowers it over time.
As the demand of the first customers is satisfied and competition enters
the market, the firm lowers the price to attract another, more price-
sensitive segment of the population. The skimming strategy gets its
name from "skimming" successive layers of cream, or customer
segments, as prices are lowered over time.
 Price skimming is a product pricing strategy by which a firm charges the highest
initial price that customers will pay and then lowers it over time.
 As the demand of the first customers is satisfied and competition enters the market,
the firm lowers the price to attract another, more price-sensitive segment of the
population.
 This approach contrasts with the penetration pricing model, which focuses on
releasing a lower-priced product to grab as much market share as possible.

How Price Skimming Works

Price skimming is often used when a new type of product enters the market.
The goal is to gather as much revenue as possible while consumer demand is
high and competition has not entered the market.

Once those goals are met, the original product creator can lower prices to
attract more cost-conscious buyers while remaining competitive toward any
lower-cost copycat items entering the market. This stage generally occurs
when sales volume begins to decrease at the highest price the seller is able to
charge, forcing them to lower the price to meet market demand.

 
Skimming can encourage the entry of competitors since other firms will notice
the artificially high margins available in the product, they will quickly enter.

This approach contrasts with the penetration pricing model, which focuses on

releasing a lower-priced product to grab as much market share as possible.
Generally, this technique is better-suited for lower-cost items, such as basic
household supplies, where price may be a driving factor in most customers'
production selections.

Firms often use skimming to recover the cost of development. Skimming is a

useful strategy in the following contexts:

 There are enough prospective customers willing to buy the product at a

high price.
 The high price does not attract competitors.
 Lowering the price would have only a minor effect on increasing sales
volume and reducing unit costs.
 The high price is interpreted as a sign of high quality.

When a new product enters the market, such as a new form of home
technology, the price can affect buyer perception. Often, items priced towards
the higher end suggest quality and exclusivity. This may help attract early
adopters who are willing to spend more for a product and can also provide
useful word-of-mouth marketing campaigns.

Price Skimming Limits

Generally, the price skimming model is best used for a short period of time,
allowing the early adopter market to become saturated, but not alienating
price-conscious buyers over the long term. Additionally, buyers may turn to
cheaper competitors if a price reduction comes about too late, leading to lost
sales and most likely lost revenue.

Price skimming may also not be as effective for any competitor follow-up
products. Since the initial market of early adopters has been tapped, other
buyers may not purchase a competing product at a higher price without
significant product improvements over the original.

What is penetration pricing?

Penetration pricing is an acquisition strategy for companies that are trying
to gain a foothold in highly competitive markets. These companies
“penetrate” the market by offering a lower price than their competitors—
enticing customers away from their current provider in an effort to gain
market share.
How penetration pricing works

By pricing below what current consumers expect to pay, companies can

increase awareness of their product or service early on and attract
customers faster. Instead of having to compete with established brands
solely on the value their product or service provides, this penetration
strategy helps companies acquire new customers through price alone.
Once these companies have grown their customer base, they can start
increasing the price to capitalize on willingness to pay. This process of
raising prices is the most difficult aspect of a penetration pricing strategy,
as customers who jump ship to go for the cheaper offering are more likely
to do so again as prices increase.

If you’re considering a penetration pricing strategy, it’s important to start

building strong customer relationships immediately to retain customers
long-term.
 

Two examples of penetration pricing

Penetration pricing is a popular tactic in the business-to-consumer (B2C)
market. The competitive nature of these products and the sheer number of
choices most consumers have make it difficult to gain a footing in a new
market without a strong acquisition strategy.

What Is Penetration Pricing?

Penetration pricing is a marketing strategy used by businesses to attract
customers to a new product or service by offering a lower price during its initial
offering. The lower price helps a new product or service penetrate the market
and attract customers away from competitors. Market penetration pricing
relies on the strategy of using low prices initially to make a wide number of
customers aware of a new product.

The goal of a price penetration strategy is to entice customers to try a new

product and build market share with the hope of keeping the new customers
once prices rise back to normal levels. Penetration pricing examples include
an online news website offering one month free for a subscription-based
service or a bank offering a free checking account for six months.

 Penetration pricing is a strategy used by businesses to attract

customers to a new product or service by offering a lower price initially.
 The lower price helps a new product or service penetrate the market
and attract customers away from competitors.
 Penetration pricing comes with the risk that new customers may choose
the brand initially, but once prices increase, switch to a competitor.
 Understanding Penetration Pricing
 Penetration pricing, similar to loss leader pricing, can be a successful
marketing strategy when applied correctly. It can often increase both
market share and sales volume. Additionally, a higher amount of sales
can lead to lower production costs and quick inventory turnover.
However, the key to a successful campaign is keeping the newly-
acquired customers.

 For example, a company might advertise a buy-one-get-one-free

(BOGO) campaign to attract customers to a store or website. Once a
purchase has been made; ideally, an email or contact list is created to
follow-up and offer additional products or services to the new customers
at a later date.

 However, if the low price is part of an introductory campaign, curiosity

may prompt customers to choose the brand initially, but once the price
begins to rise to or near the price levels of the competing brand, they
may switch back to the competitor.

 As a result, a major disadvantage to a market penetration pricing

strategy is that an increase in sales volume may not lead to an increase
in profits if prices must remain low to keep the new customers. If the
competition also lowers their prices, the companies might find
themselves in a price war, leading to lower prices and lower profits for
an extended period of time.

 Penetration Pricing vs. Skimming

 With pricing penetration, companies advertise new products at low
prices, with modest or non-existent margins. Conversely,
a skimming strategy involves companies marketing products at high
prices with relatively high margins. A skimming strategy works well for
innovative or luxury products where early adopters have low price
sensitivity and are willing to pay higher prices. Effectively, producers are
skimming the market to maximize profits. Over time, prices will reduce
to levels comparable to market prices in order to capture the rest of the
market. 

 Small businesses or those in niche markets can benefit from price

skimming when their products or services are differentiated from
competitors' and when synonymous with quality and a positive brand
image.
  Example of Penetration Pricing
 Costco and Kroger, two major grocery store chains, use market
penetration pricing for the organic foods they sell. Traditionally, the
margin on groceries is minimal. However, the margin on organic foods
tends to be higher. Also, the demand for organic, or natural, foods is
growing significantly faster than the market for non-organic groceries.
As a result, many grocers offer more extensive selections of organic
foods at premium prices to boost their profit margins. 

 However, Kroger and Costco use a penetration pricing strategy. They

are selling organic foods at lower prices. Effectively, they are leveraging
penetration pricing to increase their wallet share. While this strategy
may be risky for small grocery stores, economies of scale permit Kroger
and Costco to employ this strategy. Economies of scale essentially
means that larger companies can offer lower prices because they buy
their inventory in bulk at a volume discount. The lower costs allow
Kroger and Costco to maintain their profit margins even while
undercutting the pricing of their competition.

Peak Load Pricing

Definition: The Peak Load Pricing is the pricing strategy wherein the high
price is charged for the goods and services during times when their
demand is at peak. In other words, the high price charged during the high
demand period is called as the peak load pricing. This type of price
discrimination is based on the efficiency, i.e. a firm discriminates on the
basis of high usage, high-traffic, high demand times and low demand
times.

The consumer who purchases the commodity during the high demand
period has to pay more as compared to the one who buys during low
demand periods.

The peak load pricing is widely used in the case of non-storable

goods such as electricity, transport, telephone, security services, etc.
These are the goods which cannot be stored and hence their production is
required to be increased to meet the increased demand. Thus,
the marginal cost is also high during the peak periods as the capacity to
produce these goods is limited. And, hence, the price is set at its highest
level with an aim to shift the demand or at least the consumption of goods
and services to attain a balance between demand and supply.

For example, during summers, the electricity consumption is highest during

the daytime as several offices and educational institutes are operational
during the day time, called as a peak-load time. While the electricity
consumption is lowest during the night as all the office establishments and
educational institutes are closed by this time, called as off-peak time.
Thus, a firm will charge a relatively higher price during the daytime as
compared to the price charged at night.

The demand for many goods is larger during certain times of the day or week. For
example, roads are congested during rush hours during the morning and evening
commutes. Electricity has larger demand during the day than at night. Ski resorts
have large (peak) demands during the weekends, and smaller demand during the
week.

Peak Load Pricing = Charging a high price during demand peaks, and a lower
price during off-peak time periods.

Figure 4.4.14.4.1: Peak Load Pricing

Figure 4.4.14.4.1 demonstrates the demand for electricity during the day. Demand

curve D1D1 represents demand at off-peak hours at night. The electricity utility
company will charge a price P1P1 for the off-peak hours. The costs of producing
electricity increase dramatically during peak hours. Electricity generation reaches the
capacity of the generating plants, causing larger quantities of electricity to be
expensive to produce. For large coal-fired plants, when capacity is reached, the firm
will use natural gas to generate the peak demand. To cover these higher costs, the
firm will charge the higher price P2P2 during peak hours. The same graph
represents a large number of other goods that have peak demand at different times
during a day, week, or year (ski resorts, toll roads, parking lots, etc.).

Economic efficiency is greatly improved by charging higher prices during peak times.
If the utility were required to charge a single price at all times, it would lose the
ability to charge consumers an appropriate price during peak demand periods.
Charging a higher price during peak hours provides an incentive for consumers to
switch consumption to off-peak hours. This saves society resources, since costs are
lower during those times.

An example is electricity consumption. If consumers are charged higher prices

during peak hours, they are able to shift some electricity demand to night, the off-
peak hours. Dishwashers, laundry, and bathing can be shifted to off-peak hours,
saving the consumer money and saving society resources. Electricity companies also
promote “smart grid” technology that automatically turns thermostats down when
individuals and families are not at home… saving the consumer and society money.

The next section will discuss a two-part tariff, or charging consumers a fixed fee for
the right to purchase a good, and a per-unit fee for each unit purchased.