Price skimming definition
/What is Price Skimming?
Price skimming is the practice of selling a product at a high price, usually during the introduction of a new product when the demand for it is relatively inelastic. This approach is used to generate substantial profits during the first months of the release of a product. By doing so, a company can recoup its investment in the product. However, by engaging in price skimming, a company is potentially sacrificing much higher unit sales that it could garner at a lower price point. Eventually, a company that engages in price skimming must drop its prices, as competitors enter the market and undercut its prices. Thus, price skimming tends to be a short-term strategy designed to maximize profits.
When you engage in price skimming, the market size is small, since only early adopters are willing to pay the high price. Once early adopters have bought the product, sales volume usually declines, since the remaining potential customers are not willing to purchase at the price set by the seller. The only situation in which price skimming can be extended for a longer period is when the seller has also created a strong brand image, for which customers are willing to pay a higher price.
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Example of Price Skimming
ABC International has developed a global positioning system that can lock onto GPS satellite signals even from several feet underwater. This is a substantial improvement over existing technology, so ABC feels justified in pricing the product at $1,000, even though it only costs $150 to construct. ABC holds this price point for the first six months, while it earns back the $1 million development cost of the product, and then drops the price to $300 to deter competitors from entering the market.
Advantages of Price Skimming
There are several advantages associated with price skimming. They are as follows:
Increased profits. The entire point of price skimming is to generate an outsized profit margin by pricing products as high as possible.
Cost recovery. If a company competes in a market where the product life span is short or the market niche is small, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products.
Distributor relations. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product.
Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price.
Disadvantages of Price Skimming
There are several disadvantages associated with the price skimming method, which are as follows:
Limited market penetration. The high initial price may deter cost-sensitive customers, limiting the potential size of the market for the seller. Competitors can then capture market share by offering lower-priced alternatives while the seller targets only high-paying segments.
Encourages competitor entry. High profit margins at the start can attract competitors to enter the market quickly, eroding the seller's potential market share.
Customer alienation. Early adopters who pay the high price might feel alienated or resentful when the price drops later, leading to dissatisfaction and possible damage to brand loyalty.
Difficulty in maintaining high prices. Maintaining high prices can be challenging if customers perceive the product as overpriced, especially in competitive or price-sensitive markets.
Complexity in price adjustments. Gradual price reductions require careful timing and strategy, which can increase operational complexity. Misjudging the pace of price reduction may lead to reduced sales or lost profits.
Risk of inventory obsolescence. If a product doesn't sell well at the high price, the seller may be left with excess inventory that becomes harder to sell as competitors introduce alternatives.
Unsuitable in some markets. In markets with little technological or innovative differentiation, customers may not see enough value to justify a premium price.
Potential legal problems. In some jurisdictions, price skimming may attract scrutiny, particularly if the strategy is perceived as exploitative or monopolistic.
Ineffective against substitute products. If substitute products are readily available, customers may switch instead of paying the premium price, reducing the strategy's effectiveness.
Revenue fluctuations. High prices at launch can lead to an initial sales spike but may result in inconsistent revenue streams as prices decline over time.
By considering these disadvantages, sellers can better assess whether price skimming aligns with their market conditions, product, and long-term goals.
Evaluation of Price Skimming
This approach is useful for earning back an investment in short order, but does not position a company to compete in the industry over the long term, since it never lowers costs by building unit volume. Thus, this approach may work best for companies that focus on research and development, and produce a constant stream of new products without any intention of becoming the low-cost provider.