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. This 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 quickly obtain a substantial amount of market share. Price is one of the easiest ways to differentiate new entrants from existing market players. The overarching goal of this pricing strategy is to:
- Capture market share
- Create brand loyalty
- Switch customers from competitors
- Generate significant demand, looking to 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 (and, therefore, for utilizing economies of scale)
Illustration and Example of Penetration Pricing
A current small-sized player in the marketplace where laundry detergent sells at around $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 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 its 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, Company A will become the only seller of laundry detergent and therefore be able to establish a monopoly over the market and raise prices to a level that will provide a high profit margin.
Advantages of Penetration Pricing
- High adoption and diffusion: Penetration pricing enables a company to get its product or service quickly accepted and adopted by customers.
- Marketplace dominance: Competitors are typically caught off guard by 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 a high sales quantity that enables a firm to realize economies of scale and lower its 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, this increased goodwill creates positive word of mouth.
- High inventory turnover: Penetration pricing results in an increased inventory 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 may 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. Price cutting, while effective for making some immediate sales, rarely engenders customer loyalty.
- Damage brand image: Low prices may affect the brand image, causing customers to perceive the brand as cheap or poor quality.
- Price war: A price penetration strategy may trigger a price war. This decreases overall profitability in the market, and the only companies strong enough to survive a protracted price war are usually not the new entrant who triggered the war.
- Inefficient long-term strategy: Price penetration is not a viable long-term pricing strategy. It is usually a better idea to approach the marketplace with a pricing strategy that your company can live with, long-term. While it may then take longer to acquire a sizeable market share, such a patient, long-term strategy is more likely to serve your company better overall, and less likely to expose you to severe financial risks.
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