What is Price Skimming?
Price skimming, also known as skim pricing, is a pricing strategy in which a firm charges a high initial price and then gradually lowers the price to attract more price-sensitive customers. The pricing strategy is usually used by a first mover who faces little to no competition. Price skimming is not a viable long-term pricing strategy, as competitors eventually launch rival products and put pricing pressure on the first company.
Rationale Behind Price Skimming
Price skimming is used to maximize profits when a new product or service is deployed. Therefore, the pricing strategy is largely effective with a breakthrough product, where the firm is the first to enter the marketplace. In such a strategy, the goal is to generate the maximum profit in the shortest time possible, rather than to generate maximum sales. This enables a firm to quickly recover its sunk costs before increased competition and pricing pressure arise.
Consider the diffusion of innovation, a theory that explains the rate at which a product spreads throughout a social system. Innovators are those who want to be the first to get a new product or service. They are risk takers and price insensitive. A price skimming strategy tries to get the highest possible profit from innovators and early adopters. As the demand from these two consumer segments fills up, the price of the product is reduced, to target more price-sensitive customers such as early majorities and late majorities.
Illustration and Example of Price Skimming
Company A is a phone manufacturing company that recently developed a new proprietary technology for its phones. Company A follows a price skimming strategy and sets a skim price at P1 to recover its research and development cost. After satisfying demand at P1, the company sets a follow-on price at P2 to capture price-sensitive customers and to put pricing pressure on competitors that enter the market.
In the price skimming strategy above, Company A generates revenue = A + B with sales of Q1. With their follow-on pricing, the company generates additional revenue = C with sales of Q2-Q1. The company generates total revenue of A + B + C, with total sales of Q2.
Advantages of Price Skimming
- Perceived quality: Price skimming helps build a high-quality image and perception of the product.
- Cost recuperation: It helps a firm quickly recover its costs of development.
- High profitability: It generates a high profit margin for the company.
- Vertical supply chain benefits: It helps distributors earn a higher percentage. The markup on a $500 product is far more substantial than on a $5 item.
- Deterrence: If the firm is unable to justify its high price, then consumers may not be willing to purchase the product.
- Limitation of sales volume: A firm may not be able to utilize economies of scale if a skim price generates too few sales.
- Inefficient long-term strategy: Price skimming is not a viable long-term pricing strategy, as competitors will eventually enter the market with rival products and exert downward pricing pressure.
- Consumer loyalty: If a product that costs $1,000 at launch has a follow-on price of $200 in a couple of months, innovators and early adopters may feel ripped off. Therefore, if the firm has a history of price skimming, consumers may wait a couple of months before purchasing the product.
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