Penetration Pricing Definition
Penetration Pricing refers to a pricing policy generally used by a new entrant in the market, in which the price of the product is set at disruptively lower levels in order to gain the market share and therefore penetrate the market by attracting customers from its competitors.
A Telecommunication company, which is new in the market, comes up with an offer to provide one-month free internet services to its subscribers. This is an example of penetration pricing since, the telecommunication company, in order to enter the market, has offered to provide its internet services for free for an initial period of one month.
Penetration Pricing Strategy
Consider the following diagram, which explains how the concept of penetration pricing works.
Here, the price of a product and quantity expected to be sold are represented on the vertical and the horizontal axis respectively. Thus, against price “P1”, a quantity that is expected to be sold is “Q1”. The price is kept at a relatively higher side and as a result, less quantity of goods is expected to be sold. If the price is further reduced to P2, even more quantity i.e. Q2 could have been sold. Thus, the graph represents that a lower price attracts the sale of higher quantity, which is the subject matter in case of penetration pricing.
Penetration Pricing is generally used by sellers who are new to the already developed economyDeveloped EconomyA developed economy is the one that has a high per capita income or per capita GDP, a high degree of industrialization, developed infrastructure, technical advances, and a relatively high rank in human development, health, and education.. When a seller enters an existing market of an existing product, he may find it difficult to attract customers, being a newcomer. Such a seller can introduce penetration pricing and thereby reduce the prices of its product for an initial period of time so that customers are attracted to leave the competitors and connect with the seller. Sellers usually adopt this strategy for a particular set of products and simultaneously continue to sell the other products at their normal prices so as to maintain a reasonable profitability margin. The strategy is useful for those products where the demand is elastic to its price.
Penetration Pricing vs Price Skimming
Penetration pricing is a pricing strategy wherein a seller introduces its products at a low price for a particular period of time in order to attract a larger market share. The school of thought behind the strategy is that lower prices will attract more customers and help a company to develop a good market share by shifting the focus of the customers from the competitors to the company. Afterward, the company increases back the price of the product to its normal price.
On the other hand, price skimming is a pricing strategy wherein a company aims to maximize its profits by charging high prices for its newly introduced product. Thereafter, the prices are reduced to a normal price. This type of pricing strategy is adopted in case of unique products for which the customers may be willing to pay higher prices. A classic example of the price skimming policy is high technology-driven mobile phones, wherein owing to the features of the phone, customers are willing to pay higher prices.
Advantages and Disadvantages of Penetration Pricing
- It helps a company to establish its market share at a quicker pace and leaves the competitors with the lesser response time.
- It establishes goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price. for a company since customers promote the products automatically by word of mouth.
- Since prices are set at the lower end, it encourages the company to maintain cost controlsMaintain Cost ControlsCost control is a tool used by an organization in regulating and controlling the functioning of a manufacturing concern by limiting the costs within a planned level. It begins with preparing a budget, evaluating the actual performance, and implementing the necessary actions required to rectify any discrepancies. which lead to the efficiency of resources.
- Such type of pricing strategy discourages the new competitors to enter the market.
- As the prices are low, it may not result in sufficient profitability for the company even if a substantial quantity of the product is sold.
- If the prices are initially kept low, it becomes difficult to justify the increase in the prices later.
- The pricing strategy will not be useful for those products which have a shorter life cycle as the loss suffered by the company due to penetrative pricing in such a shorter life cycle may be substantial.
- In case the sales do not pick up quickly, it may difficult for a company since the working capital will get blocked and may lead to a shortage of funds.
Based on the type of the product and the level of competition one may decide whether it will be beneficial to opt for the penetration pricing or other pricing strategies such as skimming pricing strategy.
This has been a guide to Penetration Pricing and its definition. Here we discuss the strategy of penetration pricing along with an example, advantages, disadvantages, and differences from price skimming. You may learn more about Financing from the following articles –