What is 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 low price is likely to attract price-sensitive customers, thereby increasing the seller’s market share. While the seller may not initially make a profit at this low price point, it is building awareness with customers, who may like the features of the seller’s product so much that they stick with it once the seller eventually raises prices back to a more sustainable level.

Understanding Penetration Pricing

There are three reasons why someone would engage in penetration pricing. The first reason is to drive competitors out of the marketplace, so the company can eventually increase prices with little fear of price competition from the few remaining competitors. Another reason is to obtain so much market share that the seller can drive down its manufacturing costs due to very large production and/or purchasing volumes. Another reason is to use 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.

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.

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When to Use Penetration Pricing

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.

Example of Penetration Pricing

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. If the company signals that it will never raise its prices (such as through published articles or news releases), then this can be a strong barrier to entry.

Reduces Competition

Financially weaker competitors will be driven from the market, or into smaller niches within the market. However, the company must keep its prices low over the long term, or else new competitors will be drawn into 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. If the company can keep its sales volume high, then it can develop production efficiencies that allow it to reduce its costs, thereby allowing it to keep its prices low over the long term and maintain its market dominance.

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. This is especially likely to be the case when customers identify strongly with competitors.

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. In fact, they may leave after just one purchase, due to the poor purchasing experience.

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. Instead, it loses even more money, because it reduced its prices so much. In this situation, all competitors suffer because their profits have been wiped out - which can result in a very short price war.

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.