With every new product, companies feel tempted to build market share quickly through aggressively low prices — a tactic known as penetration pricing. But a fixation on volume usually sacrifices profitability and may ignite a price war. As a result, it is generally better to keep upward pressure on prices and to promote good industry pricing behavior. On rare occasions, however, the price lever may be the right tool to undercut competition.
High customer value, elasticity. The first kind of legitimate occasion for penetration pricing involves new or underdeveloped markets in which the benefits offered by a new product are high and customers are particularly price sensitive. If a supplier can build a presence in such markets quickly, ahead of the competition, it can disproportionately tap into latent demand, expand its share, and establish itself as the market leader. Price can be the best mechanism for implementing this strategy, especially in a market with high switching costs and no established product standards; AOL, for example, started out with very low prices and raised them over time.
This strategy can be risky, however. If consumer choice is influenced primarily by benefits rather than price, penetration pricing can only be destructive. The media, high-tech, and pharmaceutical industries provide many examples of new offerings and technologies priced aggressively to build share, which was then lost when competitors released newer and slightly better products. In markets focused on technical efficacy, these suppliers needlessly pushed price expectations lower and thus forfeited profits.
Cost-to-serve advances. Another possible occasion for penetration pricing comes when a supplier’s cost to serve will decline sharply and rapidly — often because of economies of scale or a learning-curve effect — as volume expands and fixed and variable costs per unit drop. If costs fall faster than prices, margins should rise over time.
But as the market share of a company grows, its competitors often react quickly, using low prices to minimize their market loss or to enter the market. The result can be constant downward pressure on pricing that puts target margins out of reach. Remember too that extreme care must be taken if the core driver of a product’s acceptance is benefits rather than price.
Limited capacity is another pitfall that can trap a company that is chasing low costs to serve. If penetration pricing ignites demand that can’t be met, the supplier is injured twice: margins are lost needlessly because available supplies could have been sold at higher prices, and delivery delays or failures — a factor in the overall perception of a product’s benefits — could undermine customer satisfaction.
Weak competition. Penetration pricing could also be appropriate if a company’s competitors have higher cost structures or are locked into channel agreements that limit their pricing freedom. In the basic-materials industry, for instance, Asian and Eastern European suppliers have frequently captured market share through penetration pricing once their purity and logistics standards reached minimally acceptable levels, because producers in developed countries could not match their low labor costs.
A well-known example comes from the US consumer PC market, in which Dell Computer created a lower cost structure (and eliminated costs associated with intermediaries) by selling built-to-order PCs direct to customers over the phone and the Internet. Since rivals couldn’t match Dell’s low costs, the company expanded its market share rapidly even as it secured higher margins than its rivals did.