Penetration Pricing

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.

Penetration Pricing Definition

Before we dive deep into the effects of a penetration pricing strategy, let's consider its definition.

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

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.

Penetration Pricing: Netflix

Netflix was founded by Reed Hastings and Marc Randolph in 1997. But before it became one of the world's largest streaming services, Netflix had taken over the DVD rental business.

Fig. 1. Price Penetration Netflix Example

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

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 customers' needs, starting from $8.99. The company now has 209 million subscribers worldwide and earns roughly $25 billion annually.¹

Penetration Pricing: Android

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

Fig. 2 - Samsung's price penetration strategy has been very successful in the markets

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

The strategy proves highly effective today as Android holds more than 70% of the market share worldwide.²

Penetration Pricing vs. Price Skimming

Table 1. Price Skimming vs. Price Penetration

Price penetration is the opposite of price skimming. Price penetration means pricing products at a lower end or with little margin, whereas price skimming prices 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 of 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.

Penetration Pricing Strategy

Penetration pricing strategy can range from a more subtle to a more extreme form. The subtle form is loss leader pricing, where companies sell products at a loss.

In this case, the product sold below the market price is called the loss leader. When customers purchase these products, they are "saving money". They hope to 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 the competition.

The situation often leads to a monopolistic position, after which the company raises the price to compensate for losses. However, this strategy can prevent healthy competition and is thus banned in many countries.

Penetration Pricing Advantages

Price penetration comes with three major benefits:

Penetration Pricing Disadvantages

That said, price penetration isn't without any disadvantages. Here are some limitations to 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 the brand name to "cheap bargain" or "discount", making it hard for the business to increase the price later.

• 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 a 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. However, 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 pricing are replaceable, it makes it easier for people to switch.

• Price war: Companies that adopt price penetration have their prices tied to their competitors. They may have to keep prices low at all times to stay competitive 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, where they all offer low prices for very little profit; this is unsustainable.

Market Penetration Pricing

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

One widespread 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 and a basic or a premium plan to earn revenue from frequent users.

The key to this strategy is to keep your paid plan below the competitor's benchmark to obtain customers quickly. As more people get on board, the business should shift the focus to building customer loyalty. Then, it can raise the prices to match competitors' prices and assert its position in the market.