Penetration pricing

What is Penetration pricing?

•Penetration Pricing is the charging a low initial price for a new product in order to attract customers and build market share.
•Penetration Pricing is the strategy of entering the market with a low initial price so that a greater share of the market can be capture

•Penetration Pricing is a strategy adopted for quickly achieving a high volume of sales and deep market-penetration of a new product. Under this approach, a product is widely promoted and its introductory-price is kept comparatively lower. This strategy is based on the assumption that (1) the product does not have an identifiable price-market segment, (2) it has elasticity of demand (buyers are price sensitive), (3) the market is large enough to sustain relatively low profit margins, and (4) the competitors too will soon lower their prices.
•Penetration pricing is the pricing technique of setting a relatively low initial entry price, a price that is often lower than the eventual market price. The expectation is that the initial low price will secure market acceptance by breaking down existing brand loyalties. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than short term profit maximization.

The advantages of penetration pricing to the firm

1.It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly. This can take the competition by surprise, not giving them time to react.
2.It can create goodwill among the all-important early adopter segment. This can create valuable word of mouth .
3.It creates cost control and cost reduction pressures from the start, leading to greater efficiency.
4.It discourages the entry of competitors. Low prices act as a barrier to entry (see: porter 5 forces analysis).
5.It can create high stock turnover throughout the distribution channel. This can create critically important enthusiasm and support in the channel.
6.It can be based on marginal cost pricing, which is economically efficient.

The main disadvantage with penetration pricing is that it establishes long term price expectations for the product, and image preconceptions for the brand and company. This makes it difficult to eventually raise prices. Some commentators claim that penetration pricing attracts only the switchers (bargain hunters), and that they will switch away from you as soon as you increase prices. There is much controversy over whether it is better to raise prices gradually of a period of years (so that consumers don’t notice), or employ a single large price increase (which is more efficient). A common solution to the price expectations problem is to set the initial price at the long term market price, but include an initial discount coupon. In this way, the perceived price points remain high even though the actual selling price is low. Another potential disadvantage is the low profit margins may not be sustainable long enough for the strategy to be effective.

Price Penetration is most appropriate when:

1.Product demand if highly price elastic.
2.Substantial economies of scale are available.
3.The product is suitable for a mass market (ie.: sufficient demand).
4.The product will face stiff competition soon after introduction.
5.There is inadequate demand in the low elasticity market segment for price skimming.
6.In industries where standardization is important. The product that achieves high market penetration often becomes the industry standard (eg.: Microsoft Windows) and other products, even very much superior products, become marginalized.
In interesting variant of the price penetration strategy is the bait and hook model (also called the razor and blades business model) in which an initial product is sold at a very low price but subsequently purchased products (such as refills) are sold at a higher price.
The implications of an imperfect market's downward sloping demand curve are evident in a typical new product pricing decision: should a product be launched with an aggressively low price from the start (penetration strategy), or should the product be introduced at a high initial price with subsequent price reductions as the market matures (a skimming strategy).

Again, if the product were being launched into a perfectly competitive market, there would be no pricing decision to make per se. The prevailing market price would be the price. So, the company's decision is whether or not to launch the product.

But, a substantially new product is, in effect, a mini or local monopoly. That is, for at least some segments of the market for which the product is targeted, the new product is initially unique with no substitutes. So, the innovating company has pricing leeway. The more the product is unique (i.e. differentiated) and strategically targeted, the greater the monopoly effect and the broader the pricing leeway.

From a strategic perspective, a market share focused penetration strategy is most appropriate when it is important to exploit a potentially transient first mover advantage, or to quickly establish a broad installed base in anticipation of:

(a) Cost improvements from scale, scope or experience (learning curve)

(b) Substantial complementary product sales (e.g. razors and blades, toner cartridges for printers and copiers)

(c) Subsequent upgrade cycles (software)

(d) Network effects that provide increasing benefits as more customers buy the product (e.g. fax machines)

To quickly penetrate the market, the company launches the product at relatively low price (P1), expecting to sell quantity Q1, and generate revenues equal to P1 times Q1 (the area of the shaded box). The penetration strategy capitalizes on the downward sloping demand curve since the company can pick the price and, within some reasonable bounds, optimize the resulting short-run sales quantity.

The penetration price selected (P1 in this case) will typically be driven by two factors: price elasticity and marginal cost.

Price elasticity is a measure of the market's responsiveness to a price change. If the quantity demanded increases (in percentage terms) more than a price decreases (also in percentage terms), then revenue goes up and demand is said to be price elastic at that point. Conversely, if quantity increases less than price decreases, then revenue goes down and demand is inelastic.

In most instances, companies will only consider a lower price if revenue is projected to increase, i.e. demand is elastic with respect to price. But, since the ultimate objective is profitability, a revenue increase is necessary but not sufficient: profits may decrease even if revenues increase since a company typically incurs higher total product cost (fixed plus variable) when volume increases, unless scale economies or experience effects are sufficiently large that variable costs per unit decline.

More specifically, the penetration price is usually set higher than the firm's marginal cost to bolster profitability. In some special cases, though, the penetration price may actually be lower than marginal cost. For example, a firm may be willing to incur initial losses (i.e. price below cost) if substantial future-related profitable sales are expected from complementary sales, upgrades, or price increases.

For example, HP tries to sell as many printers as it can, even at slim margins, and then make money from ink and other consumables. According to Fortune, "Every second of every day, HP makes one new printer and ten new ink-jet cartridges. The company controls 60% of the ink-jet-printer market and 55% of the laser business. Last year, HP sold about $9 billion of ink and supplies, or nearly as much as it took in from printers. But while printers carry gross profit margins of 15% to 20%, the margins on ink are 50%. Indeed, ink accounts for most of the company's profits. Call it HP's black gold."

The polar opposite to penetration pricing is called skim pricing.