Penetration Pricing Strategy

The implications of an imperfect market's downward sloping demand curve are evident in a typical new product pricing decision: should a product be launched with an aggressively low price from the start (penetration strategy), or should the product be introduced at a high initial price with subsequent price reductions as the market matures (a skimming strategy).

Again, if the product were being launched into a perfectly competitive market, there would be no pricing decision to make per se.  The prevailing market price would be the price.  So, the company's decision is whether or not to launch the product.

But, a substantially new product is, in effect, a mini or local monopoly.  That is, for at least some segments of the market for which the product is targeted, the new product is initially unique with no substitutes.  So, the innovating company has pricing leeway.  The more the product is unique (i.e. differentiated) and strategically targeted, the greater the monopoly effect and the broader the pricing leeway.

From a strategic perspective, a market share focused penetration strategy is most appropriate when it is important to exploit a potentially transient first mover advantage, or to quickly establish a broad installed base in anticipation of:

(a) Cost improvements from scale, scope or experience (learning curve)

(b) Substantial complementary product sales (e.g. razors and blades, toner cartridges for printers and copiers)

(c) Subsequent upgrade cycles (software)

(d) Network effects that provide increasing  benefits as more customers buy the product (e.g. fax machines)

The conceptual essence of a penetration strategy is illustrated below.

To quickly penetrate the market, the company launches the product at relatively low price (P1), expecting to sell quantity Q1, and generate revenues equal to P1 times Q1 (the area of the shaded box).  The penetration strategy capitalizes on the downward sloping demand curve since the company can pick the price and, within some reasonable bounds, optimize the resulting short-run sales quantity.

The penetration price selected (P1 in this case) will typically be driven by two factors: price elasticity and marginal cost.

Price elasticity is a measure of the market's responsiveness to a price change.  If the quantity demanded increases (in percentage terms) more than a price decreases (also in percentage terms), then revenue goes up and demand is said to be price elastic at that point.   Conversely, if quantity increases less than price decreases, then revenue goes down and demand is inelastic.

In most instances, companies will only consider a lower price if revenue is projected to increase, i.e. demand is elastic with respect to price.  But, since the ultimate objective is profitability, a revenue increase is necessary but not sufficient: profits may decrease even if revenues increase since a company typically incurs higher total product cost (fixed plus variable) when volume increases, unless scale economies or experience effects are sufficiently large that variable costs per unit decline.

More specifically, the penetration price is usually set higher than the firm's marginal cost to bolster profitability.  In some special cases, though, the penetration price may actually be lower than marginal cost.  For example, a firm may be willing to incur initial losses  (i.e. price below cost) if substantial future-related profitable sales are expected from complementary sales, upgrades, or price increases.  

For example, HP tries to sell as many printers as it can, even at slim margins, and then make money from ink and other consumables.  According to Fortune,  "Every second of every day, HP makes one new printer and ten new ink-jet cartridges. The company controls 60% of the ink-jet-printer market and 55% of the laser business. Last year, HP sold about $9 billion of ink and supplies, or nearly as much as it took in from printers. But while printers carry gross profit margins of 15% to 20%, the margins on ink are 50%.  Indeed, ink accounts for most of the company's profits.  Call it HP's black gold."

The polar opposite to penetration pricing is called skim pricing.