Price Penetration

The idea behind penetration pricing is to help a new product break into the market quickly and keep out competitors. This is a strategy used by many businesses, however, there are also various risks associated with price penetration. Let's take a look at this concept in more detail.

How does price penetration work?

If applied properly, price penetration can bring the company massive success. For example, lower prices can increase the rate of acceptance and allow the company to capture a substantial market share in a short period of time.

Higher sales lead to bulk purchases with discounts, which brings down production costs. As production costs decrease, the company can manufacture more goods and achieve economies of scale.

However, the drawback is if the price remains low, the business may not be able to make a sustainable profit. Also, there’s a risk of a price war with other competitors.

Pricing penetration works best when:

• The product has an elastic demand curve (the change in the price affects the product demand significantly).

• It is easy to achieve economies of scale.

• The market is large enough with sufficient demand.

• The skimming pricing strategy doesn't work — Competition remains high after the introduction stage.

• The products are subjected to standardization (e.g. Microsoft computer software)

Price penetration examples

Now that we’ve covered the basic theory, let’s walk through a couple of examples:

Netflix

Netflix was founded by Reed Hastings and Marc Randolph in 1997. But before it became the world’s biggest streaming service, Netflix had taken over the DVD rental business.

Price penetration example of Netflix, unsplash.com

The video rental industry was highly competitive at the time, though Netflix made several smart moves that allowed it to quickly attain the market-leading position. First, it announced that customers only have to wait one or two days to get their DVDs. Second, price penetration was adopted. Customers can rent out a DVD for as cheap as 50 cents.

This worked out nicely as the new business drove Blockbuster out of business and continued its path to world domination within the next twenty years.

In 1999, the company introduced a new subscription model priced from $15.95, which was later updated into a monthly subscription plan, at $19.95. In 2007, Netflix introduced its online streaming services with different pricing tiers according to the needs of the customers, starting from $8.99. Nowadays, the company has 209 million subscribers worldwide and earns roughly $25 billion per year.

Android

Another successful adoption of price penetration is by Android phone brands, most notably Samsung.

Price penetration example of Samsung, unsplash.com

As opposed to Apple who adopts a price skimming strategy for the iPhones, Android companies market their products at a lower price end. They also throw out frequent discounts to attract price-sensitive individuals and later turn them into loyal customers.

The strategy proves highly effective as today Android holds more than 70% of the market share worldwide.

Penetration pricing vs price skimming

Comparison of price skimming and price penetration, StudySmarter

Price penetration is the opposite of price skimming. Price penetration means to charge products at a lower end or with little margin whereas price skimming charges new products at a higher-end or with a large margin.

The two strategies are also suited for different kinds of products. Price skimming works well for innovative or luxury goods which tend to have a short life cycle or are made with supreme quality. They focus on attracting status-conscious customers who are willing to pay higher prices. By contrast, price penetration is often used for less exclusive goods such as cosmetics and groceries.

Types of penetration pricing

Penetration pricing strategy can range from subtle to extreme form. The subtle form is loss leader pricing where companies sell products at a loss to acquire customers. In this case, the product sold below the market price is called the loss leader. When customers purchase these products, they are "saving money". The hope is that they will use these savings for future goods and services to recoup the company’s previous loss.

At the other end is predatory pricing where the company drops the price significantly to keep out competition. The situation often leads to a monopolistic position, after which the company raises the price to make up for the losses. However, this strategy can prevent healthy competition and is thus banned in many countries.

Price penetration advantages

Price penetration comes with three major benefits:

• Fast acceptance and adoption: Low prices allow the new product to penetrate the market quickly. The business will have a much easier time convincing people to accept and adopt the product. Once people are onboard, companies can work on building customer loyalty to keep them around when the price increases.

• Free promotion from early adopters: Penetration pricing attracts many people to adopt the product in the beginning stage. If the early adopters love your product, they will provide word-of-mouth marketing campaigns for your business, a.k.a. free promotion.

• Production cost reduction: High volumes of sales means the company can buy bulk materials at a discount, which reduces the production costs. As a result, you can manufacture more products and achieve economies of scale. It also releases the pressure early due to a lack of capital.

Price penetration disadvantages

That said, price penetration isn't without its advantages. Here are some limitations of this strategy:

• Price expectation: Setting a low price upfront can create a price expectation for the product that lasts for a long time. Customers may attach your brand name to “cheap bargain ” or “discount”, which makes it hard for you to increase the price later on.

• Negative brand image: Businesses that increase their price suddenly may incur a bad reputation. Customers may feel betrayed and turn their back against such brands. In other cases, pricing your product at a lower end can give an impression of poor quality and low value.

• Brand loyalty: The biggest challenge is to make the customer stick around when the price increases. Though it may prove difficult since price penetration tends to attract many “bargain hunters'' who won't be shy to opt for lower-priced alternatives. Also, since products using penetration price are replaceable, it's also easy for people to make the switch.

• Price war: Companies that adopt price penetration have their prices tied to the competitor. They may have to keep low all the time to stay in the market. So even though they make a lot of sales, the business is not sustainable in the long run. Moreover, companies may find themselves in a price war, a situation where they all offer low prices for very little profit

How to use penetration pricing successfully

Pricing penetration is not a long-term strategy since customer acquisition is mostly based on prices. However, it’s still helpful in the introduction stage, especially when your company is new and similar products have appeared in the market.

One popular price penetration practice is to offer your product at different pricing tiers. For example, you can introduce a free plan to attract many potential customers as well as a basic and premium plan to earn revenues from frequent users.

The key of this strategy is to keep your paid plan below the competitor’s benchmark to obtain customers quickly. As more people get on board, the focus should be shifted to building customer loyalty. Then, you can raise the prices to match that of the competitors and assert your position in the market.

Banking is well-known for using this: