Penetration Pricing
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Penetration Pricing
Setting an initially low price to attract customers and quickly gain market share
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Penetration pricing is a pricing strategy that is used to quickly gain market share Total Addressable Market (TAM) Total Addressable Market (TAM), also referred to as total available market, is the overall revenue opportunity that is available to a product or service if by setting an initially low price to entice customers to purchase. This pricing strategy is generally used by new entrants First Mover Advantage The first mover advantage refers to an advantage gained by a company that first introduces a product or service to the market. The first mover advantage into a market. An extreme form of penetration pricing is called predatory 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:
Situations where penetration pricing works effectively:
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 Monopoly A monopoly is a market with a single seller (called the monopolist) but many buyers. Unlike sellers in a perfectly competitive market, a monopolist exercises substantial control over the market price of a commodity/product. over the market and raise prices to a level that will provide a high profit margin.
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Penetration pricing is the practice of initially setting a low price for one's goods or services, with the intent of increasing market share . The low price is likely to attract price-sensitive customers . The price may be set so low that the seller cannot earn a profit . However, the seller is not irrational. The intent of penetration pricing can follow any of these paths:
Drive competitors out of the marketplace, so the company can eventually increase prices with little fear of price competition from the few remaining competitors; or
Obtain so much market share that the seller can drive down its manufacturing costs due to very large production and/or purchasing volumes; or
Use excess production capacity that the seller has available; its marginal cost to produce using this excess capacity is so low that it can afford to sustain the penetration pricing for quite some time.
It is relatively common for a new entrant into a market to engage in penetration pricing, in order to grab an initial block of market share. It is particularly likely when the new entrant has a product that it cannot differentiate from those of competitors in a meaningful way, and so chooses to differentiate on price.
A business intent on following the penetration pricing strategy should have substantial financial resources, since it may incur significant losses during the early stages of this strategy.
This approach can work well in a mass market environment where large numbers of very similar products are sold, since it creates the opportunity for someone to drive down prices over very large production volumes.
If a company obtains sufficient sales volume through this pricing strategy, it can become the de facto industry standard, which makes it easier to defend its position in the market.
ABC International wants to enter the market for blue one-armed widgets. The current market price for a blue one-armed widget is $10.00. ABC has a large amount of excess production capacity, and so has an incremental cost of only $6.00 for the product. Accordingly, it elects to enter the market at a $6.25 penetration price, which it feels comfortable maintaining for the foreseeable future. Competitors rapidly evacuate the market, and ABC becomes the dominant seller of blue one-armed widgets.
The following are advantages of using the penetration pricing method:
Entry barrier. If a company continues with its penetration pricing strategy for some time, possible new entrants to the market will be deterred by the low prices.
Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market.
Market dominance . It is possible to achieve a dominant market position with this strategy, though the penetration pricing may have to continue for a long time in order to drive away a sufficient number of competitors to do so.
The following are disadvantages of using the penetration pricing method:
Branding defense. Competitors may have such strong product or service branding that customers are not willing to switch to a low-price alternative.
Customer loss . If a company only engages in penetration pricing without also improving its product quality or customer service, it may find that customers leave as soon as it raises its prices.
Perceived value . If a company reduces prices substantially, it creates a perception among customers that the product or service is no longer as valuable, which may interfere with any later actions to increase prices.
Price war . Competitors may respond with even lower prices, so that the company does not gain any market share.
This method is most useful for large companies that have sufficient resources to lower prices substantially and fight off attempts by competitors to undercut them. It is a difficult approach for a smaller, resource-poor company that cannot survive long at the paltry margins provided by penetration pricing.
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