What is Penetration Pricing?
Penetration pricing is a pricing strategy that is used to quickly gain market share by setting an initially low price to entice customers to purchase from the company. Such pricing strategy is generally used by new entrants into a market. An extreme form of penetration pricing is called predatory pricing.
Rationale Behind Penetration Pricing
It is common for a new entrant to use a penetration pricing strategy to compete effectively in the marketplace. Price is one of the easiest ways to differentiate new entrants among existing market players. The overarching goal of the pricing strategy is to:
- Capture market share
- Create brand loyalty
- Switch customers from competitors
- Generate significant demand and utilize economies of scale
- Drive competitors out of the market
Situations where penetration pricing works effectively:
- When there is little product differentiation
- Demand is price-elastic
- Where the product is suitable for a mass market (utilizing economies of scale)
Illustration and Example of Penetration Pricing
A current small-sized player in the marketplace that sells laundry detergent at $15. Company A is an international company with a large amount of excess production capacity and is, therefore, able to produce laundry detergents at a significantly lower cost. Company A decides to enter the market, employ a penetration pricing strategy, and sell laundry detergent at a sale price of $6.05. The company’s cost to produce a laundry detergent is $6.
With a marginal cost of $6 and a sale price of $6.05, Company A is making nominal profits per sale. However, the company is comfortable with this decision as their overarching goal is to switch customers over, capture as much market share as possible, and utilize economies of scale with their high production capacity.
Company A believes that its competitor will not be able to sustain itself in the long-term and will eventually exit the market. When the competitor exits the marketplace, it will become the only seller of laundry detergent and therefore be able to establish a monopoly over the market.
Advantages of Penetration Pricing
- High adoption and diffusion: Penetration pricing allows a product or service to be quickly accepted and adopted by customers.
- Marketplace dominance: Competitors are typically caught off guard in a penetration pricing strategy and are afforded little time to react. The company is able to utilize the opportunity to switch over as many customers as possible.
- Economies of scale: The pricing strategy generates high sales quantity that allows a firm to realize economies of scale and lower marginal cost.
- Increased goodwill: Customers that are able to find a bargain in a product or service are likely to return to the firm in the future. In addition, the increased goodwill creates positive word of mouth.
- High turnover: Penetration pricing results in an increased turnover rate, making vertical supply chain partners such as retailers and distributors happy.
Disadvantages of Penetration Pricing
- Pricing expectation: When a firm uses a penetration pricing strategy, customers often expect permanently low prices. If prices gradually increase, customers will become dissatisfied and may stop purchasing the product or service.
- Low customer loyalty: Penetration pricing typically attracts bargain hunters or those with low customer loyalty. Said customers are likely to switch to competitors if they find a better deal.
- Damage brand image: It may affect the brand image and cause customers to perceive the brand as cheap.
- Price war among competitors: It results in retaliation from competitors trying to maintain their market share. Pricing war may decrease profitability for the overall market.
- Inefficient long-term strategy: It is not a viable long-term pricing strategy. In many cases, firms that use the strategy face a loss of profits. In this case, the firm may not be able to recover its cost if it uses penetration pricing over an extended timeframe.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: