Price Skimming

Market Skimming Pricing

Price skimming is used during the introduction stage of a product when there's a lot of demand and little competition. It often targets early adopters - customers willing to pay high prices for high-quality, unique products. As sales drop, marketers can lower prices to attract more price-sensitive buyers. This allows the company to maximize its profits in the short term while still earning an income when the trend dies out.

The main objective of price skimming is to capture the consumer surplus and exploit its market position before competitors enter.

Figure 2 below describes how the process works.

Fig. 1. Price Skimming

The company starts at the skimming price P1, which allows it to earn the combined revenue of areas A and B. As the price drops, the company can still earn an extra profit - area C.

Market Skimming Policy

The market skimming policy works best when the following statements apply.²

1. There are enough prospective buyers for the product or service - Price skimming targets highly motivated buyers who are price insensitive. These buyers want to buy the product for better technology or prestige. A business cannot use price skimming if no such customer group exists.
2. Competitors are yet to enter the market - Many competitors will be tempted to enter the market if high demand is observed, even at high skimming prices. However, technological advancements and production costs often act as barriers to entry into the market.
3. Demand is inelastic The demand doesn't change significantly when the price changes.
4. The products are of high quality/ premium brand image - A high initial price often communicates the high quality of the product. If a brand is considered premium and is launching a new product, the increased costs are often associated with a premium brand image.
5. Low unit costs - Brands that use price skimming do not (usually) mass-produce goods. These brands often have a limit on production capacity. Even though production capacity is low, brands must ensure that producing a small volume does not cost them much. If production costs increase, profit from skimming decreases.

Price Skimming Strategy

Companies use price skimming strategy for innovative products. While implementing price skimming, marketers must understand how customers view their products. Assessing the market will help companies understand customer segments and decide on pricing.

For example, innovators and early adopters will buy new technological products first. These two customer groups are price insensitive.

Once the demand from these groups is satisfied, prices are decreased to serve the remaining price-sensitive customers. The theory that governs this difference is called diffusion of innovation theory. Table 1 outlines the characteristics of different consumers based on the diffusion of innovation theory.

Table 1. Group of customers as per diffusion of innovation theory. Source: Canadian Journal of Nursing Informatics³

Another important consideration is the lifetime of the product. In sectors like telecommunications and automobiles, there are regular new technological advancements. Hence, such sectors see rapid changes in product developments. New improvements make old products or old versions of the same products obsolete. Therefore, companies only have the option to recover costs and earn profit at the beginning of the product life cycle. For these products, price skimming may be the only option.

Price Skimming Advantages and Disadvantages

Established brands with loyal customers implement price skimming. Here are some of the advantages and disadvantages of this pricing strategy.

Read on to learn details of the advantages and disadvantages of the price skimming strategy.

Advantages of Price Skimming

Advantages of price skimming include:

• Maximize profits: As price skimming introduces products at a high price, the company has a high profit margin in the initial period. Once prices are reduced, the company still earns profits. Therefore, profits are maximized during the entire sales period.
• Dynamic pricing: Brands can adjust prices according to market conditions and the initial response from customers. Hence, price skimming provides the benefits of a dynamic pricing strategy.
• Real-time monitoring: Price skimming targets innovators and early adopters at launch. These groups provide active feedback about the product and its positioning. Businesses can then use the input to enhance future products.
• Right target customer: Price skimming helps brands segment markets into distinct customer groups. It helps maintain inventory and test how different groups react to pricing.
• Quick returns: Companies that achieve technological breakthroughs for an in-demand product can set a relatively high price during the introduction stage. Since there's no competitor around, they're most likely to earn a lucrative return that covers the initial costs of investment. Price skimming reduces the time required for the recovery of sunk costs. It provides quick returns from the market.
• Creates excitement about the product: High prices attract customer attention. The attention can turn into word-of-mouth and create buzz around the product. The built-up excitement may help the product sells faster.

Disadvantages of Price Skimming

Price skimming has many downsides if a company fails to use the strategy correctly:

• Negative effects on brand: A brand that uses extreme price skimming may face customer disappointment. Customers who buy products at a high price may feel cheated after prices are lowered. Consumers may see these brands as manipulative and opportunistic.
• Opportunity for competitors to penetrate the market: Since the firm earns high-profit margins, this may entice other companies to enter the market and sell similar products at lower prices. In the long run, this phases out the competitiveness of the original product. The company must reduce its price to continue earning profits.
• Product should have inelastic demand: Price skimming only works when the demand for a company's product is inelastic. If the product's demand is elastic, the change in the price will have a more significant impact on the quantity demanded. On the other hand, an inelastic demand reflects a slight change in the quantity demanded regardless of the price. Inelastic demand means the business can set different prices but still have customers at each price point.
• Only for the short term: Price skimming is most effective when the product is new. Since the market is not saturated and there's little or no competition, the business can take advantage of its market position to maximize profit. Competing will be more challenging when more companies enter if the price remains high. Moreover, if the business keeps its prices high for too long, price-sensitive customers may turn to cheaper competitors. This, in the long run, may lower the overall market share.

Price Skimming Examples

Fig. 2. Tesla Car Example

Tesla Price Skimming Example

Tesla is considered a leader in new pure electric vehicles. Tesla employs a similar pricing strategy in most countries, including China. Here are the pricing strategy steps that Tesla uses:

Step 1. Launch luxury sports cars and target high-income groups.

Step 2. Develop luxury electric family cars following a standard pricing strategy similar to competitors.

Step 3. Create the most cost-effective models to meet the needs of most people.

This strategy starts with price skimming and then adopts price penetration. Here is how Tesla reduced the prices of its Model 3 cars.

Table 2. Cost of Tesla Model 3 in China. Source: ICSSED 2022⁴

Hence, we can conclude that Tesla implemented a price skimming strategy and reduced prices by approximately 36%. The leading cause of the price decrease is a reduction in manufacturing costs. But a step-by-step drop in prices shows a price skimming strategy.

Apple Price Skimming Example

Apple is known for using price skimming as a launch strategy for its iPhone line of products. Upon each new model's release, the price is set high, and as the product's lifecycle progresses, the price decreases.

iPhone prices are excellent examples of Apple's price skimming strategy. When iPhone 11 was launched in 2019, it was priced at $749, which gradually reduced to $649 after a year. This strategy allowed Apple to target early adopters and enthusiasts willing to pay a premium for the latest technology, while also catering to customers looking for a more affordable option over time.