Pricing Strategy For New Products

The pricing strategy for a new product should be developed so that the desired impact on the market is achieved while the emergence of competition is discouraged. Two basic strategies that may be used in pricing a new product are skimming pricing and penetration pricing.

Skimming Pricing

Skimming pricing is the strategy of establishing a high initial price for a product with a view to "skimming the cream off the market" at the upper end of the demand curve. It is accompanied by heavy expenditure on promotion. A skimming strategy may be recommended when the nature of demand is uncertain, when a company has expended large sums of money on research and development for a new product, when the competition is expected to develop and market a similar product in the near future, or when the product is so innovative that the market is expected to mature very slowly. Under these circumstances, a skimming strategy has several advantages. At the top of the demand curve, price elasticity is low. Besides, in the absence of any close substitute, cross-elasticity is also low. These factors, along with heavy emphasis on promotion, tend to help the product make significant inroads into the market. The high price also helps segment the market. Only nonprice-conscious customers will buy a new product during its initial stage. Later on, the mass market can be tapped by lowering the price.

If there are doubts about the shape of the demand curve for a given product and the initial price is found to be too high, price may be slashed. However, it is very difficult to start low and then raise the price. Raising a low price may annoy potential customers, and anticipated drops in price may retard demand at a particular price. For a financially weak company, a skimming strategy may provide immediate relief. This model depends on selling enough units at the higher price to cover promotion and development costs. If price elasticity is higher than anticipated, a lower price will be more profitable and "relief giving."

Modern patented drugs provide a good example of skimming pricing. At the time of its introduction in 1978, Smithkline Beecham's anti-ulcer drug, Tagamet, was priced as high as $10 per unit. By 1990, the price came down to less than $2; it was sold for about 60 cents in 1994. (Tagamet was to lose patent protection in the United States in 1995, unleashing a flood of cheaper generics onto the American market.)6 Many new products are priced following this policy. Videocassette recorders (VCRs), frozen foods, and instant coffee were all priced very high at the time of their initial appearance in the market. But different versions of these products are now available at prices ranging from very high to very low. No conclusive research has yet been done to indicate how high an initial price should be in relation to cost. As a rule of thumb, the final price to the consumer should be at least three or four times the factory door cost.

The decision about how high a skimming price should be depends on two factors: (a) the probability of competitors entering the market and (b) price elasticity at the upper end of the demand curve. If competitors are expected to introduce their own brands quickly, it may be safe to price rather high. On the other hand, if competitors are years behind in product development and a low rate of return to the firm would slow the pace of research at competing firms, a low skimming price can be useful. However, price skimming in the face of impending competition may not be wise if a larger market share makes entry more difficult. If limiting the sale of a new product to a few selected individuals produces sufficient sales, a very high price may be desirable.

Determining the duration of time for keeping prices high depends entirely on the competition's activities. In the absence of patent protection, skimming prices may be forced down as soon as competitors join the race. However, in the case of products that are protected through patents (e.g., drugs), the manufacturer slowly brings down the price as the patent period draws near an end; then, a year or so before the expiration of the patent period, the manufacturer saturates the market with a very low price. This strategy establishes a foothold for the manufacturer in the mass market before competitors enter it, thereby frustrating their expectations.

So far, skimming prices have been discussed as high prices in the initial stage of a product's life. Premium and umbrella prices are two other forms of price skimming. Some products carry premium prices (high prices) permanently and build an image of superiority for themselves. When a mass market cannot be developed and upper-end demand seems adequate, manufacturers will not risk tarnishing the prestigious image of their products by lowering prices, thereby offering the product to everybody. Estee Lauder cosmetics, Olga intimate apparel, Rolex watches, Waterford Crystal, Armani suits, and Hermes scarves are products that fall into this category.

Sometimes, higher prices are maintained in order to provide an umbrella for small high-cost competitors. Umbrella prices have been aided by limitation laws that specify minimum prices for a variety of products, such as milk.

Du Pont provides an interesting example of skimming pricing. The company tends to focus on high-margin specialty products. Initially, it prices its products high; it then gradually lowers price as the market builds and as competition grows. Polaroid also pursues a skimming pricing strategy. The company introduces an expensive model of a new camera and follows up the introduction with simpler lower-priced versions to attract new segments.

Penetration Pricing

Penetration pricing is the strategy of entering the market with a low initial price so that a greater share of the market can be captured. The penetration strategy is used when an elite market does not exist and demand seems to be elastic over the entire demand curve, even during early stages of product introduction. High price elasticity of demand is probably the most important reason for adopting a penetration strategy. The penetration strategy is also used to discourage competitors from entering the market. When competitors seem to be encroaching on a market, an attempt is made to lure them away by means of penetration pricing, which yields lower margins. A competitor's costs play a decisive role in this pricing strategy because a cost advantage over the existing manufacturer might persuade another firm to enter the market, regardless of how low the margin of the former may be.

One may also turn to a penetration strategy with a view to achieving economies of scale. Savings in production costs alone may not be an important factor in setting low prices because, in the absence of price elasticity, it is difficult to generate sufficient sales. Finally, before adopting penetration pricing, one must make sure that the product fits the lifestyles of the mass market. For example, although it might not be difficult for people to accept imitation milk, cereals made from petroleum products would probably have difficulty in becoming popular.

How low the penetration price should be differs from case to case. There are several different types of prices used in penetration strategies: restrained prices, elimination prices, promotional prices, and keep-out prices. Restraint is applied so that prices can be maintained at a certain point during inflationary periods. In this case, environmental circumstances serve as a guide to what the price level should be. Elimination prices are fixed at a point that threatens the survival of a competitor. A large, multiproduct company can lower prices to a level where a smaller competitor might be wiped out of the market. The pricing of suits at factory outlets illustrates promotional prices. Factory outlets constantly stress low prices for comparable department-store-quality suits. Keep-out prices are fixed at a level that prevents competitors from entering the market. Here the objective is to keep the market to oneself at the highest chargeable price.

A low price acts as the sole selling point under penetration strategy, but the market should be broad enough to justify low prices. Thus, price elasticity of demand is probably the most important factor in determining how low prices can go. This point can be easily illustrated.7 Convinced that shoppers would willingly sacrifice convenience for price savings, an entrepreneur in 1981 introduced a concentrated cleaner called 4 + 1. Unlike such higher-priced cleaners as Windex, Fantastik, and Formula 409, this product did not come in a spray bottle. It also needed to be diluted with water before use. The entrepreneur hoped for 10 percent of the $200 million market. But the product did not sell well. The product was not as price elastic as the entrepreneur had assumed. Though the consumer tends to talk a lot about economy, the lure of convenience is apparently stronger than the desire to save a few cents. Ultimately, 4 + 1 had to be withdrawn from most markets.

Unlike Du Pont, Dow Chemical Company stresses penetration pricing. It concentrates on lower-margin commodity products and low prices, builds a dominant market share, and holds on for the long haul. Texas Instruments also practices penetration pricing. Texas Instruments starts by building a large plant capacity. By setting the price as low as possible, it hopes to penetrate the market fast and gain a large market share.

Penetration pricing reflects a long-term perspective in which short-term profits are sacrificed in order to establish sustainable competitive advantage. Penetration policy usually leads to above-average long-run returns that fall in a relatively narrow range. Price skimming, on the other hand, yields a wider range of lower average returns.

Continue reading here: Pricing Strategies For Established Products

Was this article helpful?