Estimating the size of a market at various price points clarifies the range of pricing options, suggests which price models to use at any price and volume point, and increases the accuracy of estimates of profitability along the spectrum and of the unit-cost calculations needed to define the price floor.
Setting the Release Price
After a company has determined the full range of its pricing options and the market’s size at various points within that range, it is ready to formulate the release price. Targeting the largest market segment within the range might be tempting, but maximizing volume doesn’t necessarily maximize profits (see “Penetration Pricing,” at the end of this article). In particular, four aspects of new-product pricing may counsel against targeting the largest market, especially if doing so means setting the price low.
Reference price. The release price minus any discounts or other incentives establishes the market’s first reference point for the product’s true value as judged by its maker. More than any press release, sales pitch, or catalog description, the reference price tells the market what a company really thinks a new product is worth. An excessively low reference price can handicap its long-term profitability — the low price might hasten its penetration of the market, but the resulting lower margins forgo the future profits a higher price would have captured once a customer base had been established. A low reference price is particularly damaging if it conflicts with the value position the company is trying to establish or if market demand has been underestimated.
Competitors’ reactions. Especially for evolutionary products, a low price that noticeably shifts market share will probably trigger a destructive price war: competitors usually can’t react immediately by improving the benefits of their own products, so they often cut prices instead. (See Robert A. Garda and Michael V. Marn, “Price Wars,” The McKinsey Quarterly, 1993 Number 3, pp. 87—100.) A higher reference price, by contrast, suggests that a company is targeting profits rather than market share and might therefore generate few if any immediate reactions from competitors.
Life cycle strategy. If an early-adopter segment is willing to pay a premium for a product, the company that makes it may wish to consider a high release price to capture the extra value, with planned reductions down the road to attract latecomers. Along with capturing more revenue over the life of a product, this strategy can also help companies match demand to production capacity for a new product.
Cannibalization. Companies must also carefully consider how new wares will affect their current ones. If an older product remains viable, a company might try to manage the cannibalization problem by giving its new product a higher release price targeting a smaller segment of customers. By contrast, if a product line is being retired, a lower release price for a new offering may be appropriate to shift customers to it as quickly as possible.