Penetration Pricing – How does Penetration Pricing Work and When to use it?

by Maximilian Claessens
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Penetration Pricing - How does Penetration Pricing Work?

Some companies will swoop into a market with radically low prices as a strategy of attracting new clients in a competitive bid for market share. This is called a penetration pricing strategy. We’ll explore what penetration pricing is, how it works, how it compares to other pricing strategies, when it should be used and also look at some penetration pricing examples.

What Is Penetration Pricing?

Penetration pricing is a pricing strategy that involves offering goods and services at a significantly lower cost than those given by incumbent brands in a market. The strategy’s purpose is to take a bite out of another brand’s consumer base, even if it means low short-term profit margins.

How Does Penetration Pricing Work?

Penetration Pricing works by presenting an initial price that is significantly lower than the market’s going rate. An effective penetration strategy ensures that a company not only gains customers for a single transaction, but also keeps them as long-term customers. There are two options for accomplishing this.

  • Establishing economies of scale: An upstart company can build brand loyalty by keeping pricing low if it can attract a large number of new customers. This may be viable only with large sales volumes, which keep marginal costs low and allow companies to live on sheer transaction volume.
  • Gradually raising prices: Another price penetration technique is to eliminate all competition before gradually raising prices to break even. When a company is in its early stages and has access to a large amount of borrowed capital, it can do so. They effectively lose money on early transactions, then gradually ramp up to a relatively high price that can be sustained over time after the competition is priced out. While this may be advantageous in the long run for the brand, it may harm customers by removing competing markets. In certain nations, monopolistic commercial methods like this are banned.

This principle holds true for innovative products as well. To encourage individuals to try a new product or service, the price barrier is lowered. The company establishes a price that is a steal for its unique value while still being less expensive than alternatives. Competitors have less time to react before the company gains market share and establishes itself as the new norm.

When demand for a new product or service is expected to be high, penetration pricing is commonly applied. The aim is that the higher sales volume will compensate for the lower cost.

Penetration Pricing vs. Price Skimming

In another article, we have explored an alternative entry-pricing strategy in detail: Price Skimming. The following is a comparison of penetration pricing and price skimming.

Penetration Pricing may be defined as a pricing strategy used by a company to attract a large number of customers, in which the product is first supplied at a low price. Penetration pricing is thus mainly about volume. Price skimming, on the other hand, refers to a pricing strategy in which a high price is asked at the beginning of the product’s lifecycle in order to maximize profit.

By selling goods at low prices, penetration pricing tries to secure a large market share. In contrast, the goal of utilizing a price skimming strategy is to maximize profit from clients by providing the product at the highest price.

When demand for a product is relatively elastic, the penetration pricing strategy is used. Price skimming, on the other hand, is utilized when the product’s demand is inelastic.

The profit margin for penetration pricing is minimal, while the profit margin for price skimming is (if done right) high.

The company sells a large quantity of goods since the price of the product is initially low in penetration pricing. In price skimming, volume is sacrificed in order to maximize margins.

Penetration Pricing in Comparison with Loss Leader Pricing and Predatory Pricing

There are a few pricing strategies that sound very similar to penetration pricing but differ significantly. Here’s a closer look at each one of them:

  • Loss leader pricing is a somewhat different pricing strategy that is banned in half of the states in the US. To attract more customers, businesses sell a product or service at a loss—or with a very small margin. Customers are supposed to buy these “loss leaders” and then use the money saved to buy the company’s other, more profitably priced goods.
  • Predatory pricing is prohibited in the United States as well as in many other countries in the world. Predatory pricing is when a company cuts its costs drastically in order to drive competitors out of the market. The corporation becomes a monopoly if it is left unchecked or unregulated. To recuperate losses and maintain their position, the corporation then hikes prices above market levels. Predatory pricing eliminates the potential of healthy competition and benefits for neither consumers nor businesses.

Who Uses Penetration Pricing?

Penetration pricing is used by only a few types of enterprises.

  • New entrants: New entrants into an existing market often use market penetration pricing to try to steal customers from the market leaders. The idea is that by offering significantly lower prices in their initial offering, these businesses will attract customers away from higher-priced brands.
  • Brands that have been around for a long time are breaking into new markets: Penetration pricing is frequently used by large, mass-market brands looking to break into a lucrative new market. Some large online merchants, for example, have employed penetration pricing methods to launch new products from their numerous in-house brands.
  • Price-elastic brands: Brands with price-elastic products, or those whose demand is heavily dependent on the price, are more likely to employ penetration pricing techniques.

How is Penetration Pricing Related to Market Penetration?

The act of an organization wedging itself into an existing market and claiming new clients from established brands is known as market penetration. There are several methods for gaining market share upon penetration, including penetration pricing. Price Skimming (where you start with high rates and progressively drop them to attract budget-conscious customers), heavy advertising (where prices mirror the going market rate but you attract people through ad campaigns), and word-of-mouth marketing (where you count on early adopters to organically spread the word about your new brand) are just a few examples.

Principal Advantages of Penetration Pricing

Penetration pricing has a number of benefits for both organizations and customers.

  • Rapid customer conversion: When evaluating brands, some customers consider price point to be the most important factor. Manufacturers, service providers, and merchants can swiftly attract new customers by delivering the best possible pricing.
  • Long-term market dominance: Companies have achieved long-term market dominance using penetration pricing schemes. They achieve this by establishing large economies of scale, in which millions of low-profit-margin transactions add up to massive overall profits.
  • Customers benefit in the short term: Customers benefit from competitive markets, especially those who are ready to forego brand loyalty in exchange for a lower price.

Principal Disadvantages of Penetration Pricing

Penetration pricing can cause market upheaval, but this isn’t always a good thing.

  • Predatory pricing: Penetration pricing can soon deteriorate into predatory pricing, where companies with a lot of cash can afford to lose a lot of money. Their small-business competitors, on the other hand, cannot afford to have negative profit margins. As a result, huge companies evict mom-and-pop shops, creating a climate conducive to monopoly formation. As a result, predatory pricing is prohibited in the US.
  • Price wars that aren’t sustainable: Predatory pricing might start a price war with established brands. These can be beneficial for customers who switch between competitors in pursuit of lower pricing and better service. Price wars, on the other hand, tend to be unsustainable over time, causing enterprises to exhaust all available cash and credit.
  • Reduced brand image: Being the cheapest location in town isn’t always advantageous. Customers sometimes connect low costs with inferior quality, especially when a company lacks a long-standing reputation.

Examples of Penetration Pricing

Netflix

Netflix is a great example of how market penetration pricing may be used to beat out a big part of the competition. DVD rentals were popular in the late 1990s and early 2000s. Despite dominating the home entertainment market, Blockbuster was known for late fines and limited offerings.

Netflix had a one-of-a-kind proposal. Customers might access a greater movie selection without incurring late fees if they could wait a day or two for their DVDs to arrive. To entice Blockbuster customers, Netflix stressed convenience and affordability from the start.

For the $15.95 subscription plan in 2000, Netflix users could rent four movies at a time with no return deadlines. Regular moviegoers could thus rent DVDs for as little as $1 each day, compared to $4.99 for a three-day rental at Blockbuster.

Netflix was able to grow its member base and reach profitability in 2003, five years after it first opened, thanks to penetration pricing and a unique idea.

Customers were able to test their new service and make the transfer because of the cheap initial price point. The company’s easy-to-use online streaming offering moved it into the future in 2007. Blockbuster filed for bankruptcy in 2010 due to intense competition from Netflix and Redbox, another new rental provider.

More Penetration Pricing Examples

The penetration pricing strategy is used in a variety of ways by businesses. Some of them use discounts, promotions, and other gifts to entice clients in addition to having a low price for their core product. Here are a few examples of what we’re talking about:

  • Internet and cable providers: To attract new users, cable companies frequently provide free streaming services or more channels. Despite the fact that most perks have a time limit, they are nevertheless useful. These bonuses and incentives help businesses stand out in a crowded market.
  • Food and beverage firms: Snack and beverage companies frequently release new items and tastes at low rates to get people to try them. Take, for example, the recently popular hard-seltzer market. A new company might make a big sensation by selling a lime flavor for $1,50 less than the competition.
  • Cell phone carriers and smartphones: In exchange for a long-term commitment, several carriers offer clients low-cost or free smartphones. This method is also used by technology businesses that make phones. Customers develop brand loyalty and Android obtains higher market penetration as a result of low-cost Android phones. On the other hand, Apple engages in price skimming. They start with as high a price as their consumers are willing to pay and gradually lower it. The initial high price establishes their luxury brand reputation, and as the product’s price gradually decreases, they “skim” price-sensitive clients from competitors.
  • Streaming: The streaming video market is an example of penetration pricing. Legacy companies often allow prices to rise over time since they rely on customer loyalty to maintain their subscription bases. As a method to attract potential consumers looking for lower prices, upstart streaming services have launched their initial offerings at significantly lower prices. If forced to select between two streaming service providers, the upstarts expect that some customers will choose inexpensive rates above brand loyalty when it comes to entertainment.

These pricing and marketing strategies are used by entrepreneurs to attract new clients and promote repeat business.

Final Thoughts

Penetration pricing is a powerful entry-pricing strategy, but at the same time is a challenging one to implement while securing long-term profitability. It can be a good approach to attract customers, generate goodwill, and set yourself apart from the competition. However, in the early stages of a business, it might lead to uncommitted clients and narrow margins.

A break-even analysis could assist you decide whether penetration pricing is the proper strategy.

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