Definition of Penetration Pricing
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 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
- Uses 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.
The Penetration Pricing Calculation
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.
Advantages of Penetration Pricing
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.
Disadvantages of Penetration Pricing
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.
Evaluation of Penetration Pricing
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.