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Price Skimming

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Price Skimming

Samsung is one of the most proficient companies when it comes to price skimming. You may have noticed that Samsung drops the prices of its phones almost 2 to 3 months after their launch. This strategy allows Samsung to quickly catch the initial buzz around the product and recover its investments. This eventual price decrease is known as price skimming.

Price Skimming Definition

Skimming means removing something layer by layer. Like skimmed milk! Did this pop into your head when you read price skimming? Just as skimmed milk is produced to attract certain customer segments, price skimming captures customers' attention when a new product is introduced to the market.

Price skimming involves charging a relatively high price for a short time when a new, innovative, or much-improved product is launched onto a market.1 The company then lowers the product's price when demand declines and the market becomes saturated.

Price skimming aims to 'skim' customers willing to pay a premium price for a product. 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).

Once the initial excitement disappears, the company reduces the product's price and targets price-conscious buyers. Companies may also reduce prices when competitors launch similar products at a lower price.

One important point to note here is that price skimming is a pricing strategy used for products in the initial stage of the product life cycle.

Many iPhone lovers are willing to stand in long lines to purchase the latest iPhone as it launches, even though they know the price will drop a few months later.

Premium Pricing vs. Price Skimming

Now that you understand the basic idea of price skimming, you might have thought, "Isn't price skimming just premium pricing?". Although the two sound quite similar, price skimming is a different approach to premium pricing.

Premium pricing involves keeping the price of one (or more) of your goods or services higher than competitors.

Using premium pricing, the company tactically sets the high price to attract buyers to its products. Due to the higher pricing, the company hopes customers view its product as higher quality than a competitor's substitute product. Premium pricing is founded on the idea of manipulating customer perceptions based on pricing. On the other hand, price skimming is a strategy whereby the price of the product is only high when it is introduced to the market. After the product reaches its saturation phase or if new product developments are introduced, the company will decrease the product's price.

Market Skimming Pricing

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 - customers willing to pay high prices for high-quality, unique products. As sales drop, marketers can lower prices to attract more price-sensitive buyers. This allows the company to maximize 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 market position before competitors enter.

Figure 2 below describes how the process works.

Price Skimming Market skimming pricing StudySmarterFig. 1. Price Skimming

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

Market Skimming Policy

The price skimming approach works best when the following statements apply.2

1. There are enough prospective buyers for the product or service - Price skimming targets highly motivated buyers who are price insensitive. These buyers want to buy the product for better technology or prestige. A business cannot use price skimming if no such customer group exists.

2. Competitors are yet to enter the market - Many competitors will be tempted to enter the market if high demand is observed, even at high skimming prices. However, technological advancements and production costs often act as barriers to entry into the market.

If technology is readily available and production costs are low, competitors will not take much time to storm into the market and offer lower prices. A competitor using penetration pricing can damage the effectiveness of price skimming.

3. Demand is inelastic - The demand doesn't change significantly when the price changes.

4. The products are of high quality/ premium brand image - A high initial price often communicates the high quality of the product. If a brand is considered premium and is launching a new product, the increased costs are often associated with a premium brand image.

Price skimming may not work with brands that produce affordable, essential daily goods.

Nike, a well-known sports shoe and clothing brand, uses price skimming while launching limited edition shoes. But Primark, the affordable clothing brand, will use price penetration when introducing new clothing designs.

5. Low unit costs - Brands that use price skimming do not (usually) mass-produce goods. These brands often have a limit on production capacity. Even though production capacity is low, brands must ensure that producing a small volume does not cost them much. If production costs increase, profit from skimming decreases.

The Swiss watchmaker Rolex can use price skimming as the unit cost of producing a small volume is almost the same as manufacturing higher volumes. On the other hand, bread companies like Kingsmill and Warburtons take advantage of economies of scale and cannot produce smaller quantities for low prices.

Price skimming strategy

Companies implement price skimming for innovative products. While implementing price skimming, marketers must understand how customers view their products. Assessing the market will help companies understand customer segments and decide on pricing.

For example, innovators and early adopters will buy new technological products first. These two customer groups are price insensitive.

Once the demand from these groups is satisfied, prices are decreased to serve the remaining price-sensitive customers. The theory that governs this difference is called diffusion of innovation theory. Table 1 outlines the characteristics of different consumers based on the diffusion of innovation theory.

Group title

Characteristics

Overall percentage

Innovators

Technology enthusiasts

2.5%

Early Adopters

Visionaries

13.5%

Early Majority

Pragmatics

34%

Late majority

Conservatives

34%

Laggards

Skeptics

16%

Table 1. Group of customers as per diffusion of innovation theory. Source: Canadian Journal of Nursing Informatics3

Another important consideration is the lifetime of the product. In sectors like telecommunications and automobiles, there are regular new technological advancements. Hence, such sectors see rapid changes in product developments. New improvements make old products or old versions of the same products obsolete. Therefore, companies only have the option to recover costs and earn profit at the beginning of the product life cycle. For these products, price skimming may be the only option.

All products have a life cycle. A business may decide to continue producing the same product or to update the product. In any case, the company must know how that particular product will exit the market. Will the product be replaced by an updated version or vanish from the market? The business should consider an exit strategy as the product's life cycle determines profits.

Price Skimming Advantages and Disadvantages

Established brands with loyal customers implement price skimming. Here are some of the advantages and disadvantages of this pricing strategy.

Advantages of Price Skimming

1. Maximize profits

As price skimming introduces products at a high price, the company has a high profit margin in the initial period. Once prices are reduced, the company still earns profits. Therefore, profits are maximized during the entire sales period.

2. Dynamic pricing

Brands can adjust prices according to market conditions and the initial response from customers. Hence, price skimming provides the benefits of a dynamic pricing strategy.

3. Real-time monitoring

Price skimming targets innovators and early adopters at launch. These groups provide active feedback about the product and its positioning. Businesses can then use the input to enhance future products.

4. Right target customers

Price skimming helps brands segment markets into distinct customer groups. It helps maintain inventory and test how different groups react to pricing.

5. Quick returns

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 that covers the initial costs of investment. Price skimming reduces the time required for the recovery of sunk costs. It provides quick returns from the market.

6. Creates excitement about the product

High prices attract customer attention. The attention can turn into word-of-mouth and create buzz around the product. The built-up excitement may help the product sells faster.

Disadvantages of Price Skimming

Price skimming has many downsides if a company fails to use the strategy correctly.

1. Negative effects on brand

A brand that uses extreme price skimming may face customer disappointment. Customers who buy products at a high price may feel cheated after prices are lowered. Consumers may see these brands as manipulative and opportunistic.

2. Opportunity for competitors to penetrate the market

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.

3. Product should have inelastic demand

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 slight change in the quantity demanded regardless of the price. Inelastic demand means the business can set different prices but still have customers at each price point.

4. Only for the short term

Price skimming is most effective when the product is new. Since the market is not saturated and there's little or no competition, the business can take advantage of its market position to maximize profit. Competing will be more challenging when more companies enter if the price remains high. Moreover, if the business keeps its prices high for too long, price-sensitive customers may turn to cheaper competitors. This, in the long run, may lower the overall market share.

Price Skimming Examples

Price skimming Tesla price skimming StudySmarterFig. 2. Tesla Car Example

Tesla is considered a leader in new pure electric vehicles. Tesla employs a similar pricing strategy in most countries, including China. Here are the pricing strategy steps that Tesla uses:

Step 1. Launch luxury sports cars and target high-income groups.

Step 2. Develop luxury electric family cars following a standard pricing strategy similar to competitors.

Step 3. Create the most cost-effective models to meet the needs of most people.

This strategy starts with price skimming and then adopts price penetration. Here is how Tesla reduced the prices of its Model 3 cars.

Date

Cost (Yuan)

August 2019

363,900

November 2019

355,800

April 2020

291,800

October 2020

269,700

July 2021

235,900 (subsidised)

Table 2. Cost of Tesla Model 3 in China. Source: ICSSED 20224

Hence, we can conclude that Tesla implemented a price skimming strategy and reduced prices by approximately 36%. The leading cause of the price decrease is a reduction in manufacturing costs. But a step-by-step drop in prices shows a price skimming strategy.

Skimming pricing - Key takeaways

  • Price skimming involves charging a relatively high price for a short time when a new, innovative, or much-improved product is launched onto a market
  • The following factors are necessary for price skimming to be successful:
    • Availability of buyers who are willing to pay high prices
    • Premium brand image
    • Low unit costs for producing small volumes
    • Entry barriers
  • A competitor using penetration pricing can damage the effectiveness of price skimming.


References

  1. Katerina Polenovich-Price Skimming on a Successful Marketing Strategy-Academia
  2. Dolgui, Alexandre, and Jean-Marie Proth. Pricing strategies and models. Annual Reviews in Control. 2010.
  3. Kaminski, June. Diffusion of innovation theory. Canadian Journal of Nursing Informatics. 2011.
  4. Zhou, Yi. Research on Influencing Factors of Tesla Pricing Strategy. In 2022 7th International Conference on Social Sciences and Economic Development (ICSSED 2022), pp. 107-114. Atlantis Press, 2022.

Frequently Asked Questions about Price Skimming

Price skimming in marketing is a pricing strategy. It involves charging a relatively high price for a short time when a new, innovative, or much-improved product is launched onto a market. The company then lowers the product's price when demand declines and the market becomes saturated.

A price skimming strategy aims to 'skim' customers willing to pay a premium price for a product. 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). Once the initial excitement disappears, the company reduces the product's price and targets price-conscious buyers. Companies may also reduce prices when competitors launch similar products at a lower price.

An example of a price skimming strategy can be observed through Apple's iPhones. 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's early adopters are aware of the cost but are willing to pay for it anyway due to the cutting-edge technology. 

Price skimming involves charging a relatively high price for a short time when a new, innovative, or much-improved product is launched onto a market. The company then lowers the product's price when demand declines and the market becomes saturated.

Some of the advantages of price skimming include profit maximization, quick returns, real-time monitoring, and creating word-of-mouth. The disadvantages of price skimming include its short-term nature, the opportunity for competitors to enter the market, and possible negative effects on the brand.

Final Price Skimming Quiz

Question

What is price skimming?

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Answer

Price skimming involves charging a relatively high price for a short time when a new, innovative, or much-improved product is launched onto a market

Show question

Question

Who are early adopters?

Show answer

Answer

Customers who are willing to pay a premium for a new product.

Show question

Question

When do companies implement price skimming?

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Answer

Companies implement price skimming while launching new and anticipated product.

Show question

Question

What is penetration pricing?

Show answer

Answer

In penetration pricing, product prices are low to attract many customers and capture the market quickly.

Show question

Question

Which factors are necessary for the success of price skimming?

Show answer

Answer

The following factors are necessary for price skimming to be successful:
  • Availability of buyers who are willing to pay high prices 
  • Premium brand image
  • Low unit costs for producing small volumes
  • Entry barriers

Show question

Question

Why is a premium brand image necessary for price skimming?

Show answer

Answer

A high initial price often communicates the high quality of the product. If a brand is considered premium and is launching a new product, the increased costs are often associated with a premium brand image.

Show question

Question

Why should the unit cost of producing a small volume be low for price skimming?

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Answer

The unit cost of producing small volumes should be low for price skimming because for small volumes, if production cost increases, profit from skimming decreases.

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Question

What barriers stop competitors from entering the market when a brand is implementing price skimming?

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Answer

Technological advancements and production costs.

Show question

Question

What is diffusion of innovation theory?

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Answer

The pattern at which consumers are willing to adopt new products.

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Question

According to the diffusion of innovation theory, which two groups are price insensitive?

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Answer

Innovators and early adopters

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Question

Which of the following groups are price insensitive?

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Answer

Innovators

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Question

How does price skimming benefit from the advantages of dynamic pricing?

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Answer

Brands can adjust prices according to market conditions and the initial response from customers. Hence, price skimming provides the benefits of a dynamic pricing strategy.

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Question

How does price skimming help in real-time market monitoring?

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Answer

Price skimming targets innovators and early adopters at launch. These groups provide active feedback about the product and its positioning. Businesses can then use the input to enhance future products.

Show question

Question

How can competitors reduce the effectiveness of price skimming?

Show answer

Answer

Seeing high prices, competitors may storm the market by using penetration pricing.

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Question

Why should products have inelastic demand when using price skimming?

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Answer

The quantity demanded of a product should not change according to price changes. If demand for a product is elastic, customers may demand higher quantities after its price decreases, which means that the product fails to satisfy customers at a skimming price.

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