Price Skimming

Pricing decisions are decisions to be made about the price of a product or service. It is an important element of the marketing mix and is determined by taking into account multiple factors such as production costs, competitor price, customer’s willingness to pay, market conditions, brand image, and product quality. Let's examine how price skimming works in the marketing context.

Importance of price skimming

Pricing decisions allow the company to achieve its financial goals and maintain its position in the market. In addition, they can help to maintain price consistency among products within a company's portfolio as well as fight off competition.

In marketing, the optimal price is one that is close to maximum customer willingness to pay, which balances between price floor (the point below which the company incurs losses) and price ceiling (the point where there is no demand for the product).

To determine the optimal price, companies often employ various strategies and tactics, two of which are price skimming and price penetration. Price skimming strategy will be discussed in this article.

Strategies of price skimming

This strategy works well in the innovative space where there’s a high demand from the early adopters and the demand is inelastic (the change in the price doesn't strongly affect the demand).

The opposite of skimming pricing is penetration pricing, where the price is low at first, then increases over time.

How does price skimming work?

Price skimming is used during the introduction stage of a product, when there's a lot of demand and little competition. It often targets early adopters who are willing to pay high prices for high-quality and unique products. As sales drop, marketers can lower the price to attract more price-sensitive buyers. This allows the company to maximise its profits in the short term while still earning an income when the trend dies out.

The main objective of price skimming is to capture the consumer surplus and exploit its monopolistic position before the competitors enter.

Figure 1 below describes how the process works:

Figure 1. Price skimming. StudySmarter

The company starts at the skimming price P1 which allows it to earn the revenue of A and B. As the price drops, the company can still earn an extra profit - Part C.

Examples of price skimming

Apple is a great example of a price-skimming brand. The company releases a new product with a premium price, then drops it a few months later to open the door for other buyers. Apple early adopters are aware of the cost but are willing to pay for it anyway due to the cutting-edge technology.

But there's a twist to Apple's price skimming strategy as well. In some cases, the company maintains and defines the price of its product by adding significant value to future iterations.

The price of the MacBook Air hasn't changed much over the years. It was released in 2019 at a base price of US$1,099 (with a discount of $100). In 2021, the price was cut down to $999. Apple justifies this by installing its M1 chip in the latest version that runs faster and has longer battery life.

Price skimming advantages

There are many benefits for a company to adopt price skimming:

High returns on investment

Companies that achieve technological breakthroughs for an in-demand product can set a relatively high price during the introduction stage. Since there’s no competitor around, they’re most likely to earn a lucrative return which not only covers the initial costs of investment but also funds future projects.

Prestigious brand image

Many people associate price with quality and status. By pricing the product at a higher end, you can build a prestigious brand image to attract status-conscious consumers. On the other hand, a lower price can give the impression of your product being poorly made or inferior.

Profit maximization

Price skimming differentiates the super fans and early adopters from price-sensitive customers. This allows you to:

• Gain valuable insights about the market demand. If the early sales are positive, that means your product has a high demand. You should continue making the product to maximise the potential profit.

• Determine the price point for profit maximization. Setting different prices allow you to the maximum willingness to pay by customers from different segments. With this, you can come up with a pricing strategy to maximize future profits.

Feedback and free promotion from early adopters

Early adopters are your first 'testers' and can offer you valuable feedback to improve the product before reaching a wider customer base. In addition, they may become brand evangelists and provide word-of-mouth marketing campaigns for your business. This means no promotion charge on your side.

Price skimming disadvantages

However, price skimming isn't without its disadvantages. Here are three consequences marketers need to look out for when adopting it.

Not a long-term strategy

Price skimming is most effective when the product is new. Since the market is not saturated and there’s little or no competition around, you can take advantage of the monopolistic position to maximise profit. When more companies enter, it’ll be harder to compete if your price remains high. Moreover, if you keep the price high for too long, a lot of price-sensitive customers will turn to cheaper competitors. This in the long run may lower your overall market share.

Only works if the demand is inelastic

Price skimming only works when the demand for a company's product is inelastic. If the product's demand is elastic, the change in the price will have a more significant impact on the quantity demanded. On the other hand, an inelastic demand reflects a small change in the quantity demanded regardless of the price. Having an inelastic demand means that you can set different prices but still have customers at each price point.

High returns attract competition

Since the firm earns high-profit margins, this may entice other companies to enter the market and sell similar products at lower prices. In the long run, this phases out the competitiveness of the original product. The company must reduce its price to continue earning profits.