Market-Based Pricing: Skimming, Penetration, Discrimination and Other Strategies

A mobile phone maker launches a new handset. It could price it high, sell to enthusiasts who must have it first, and cut the price as the novelty fades. It could price it low, fill the market quickly and make rivals think twice about entering. It could match its competitors’ prices and compete on service. Or it could charge business buyers more than students for the same device.

Each choice is a market-based pricing strategy, and each suits some situations and ruins others. The examiner expects a candidate to name the strategy that fits the facts, to say why, to show the numbers where numbers are given, and to point out the risks.

This topic explains the main market-based strategies (skimming, penetration, parity, price discrimination, loss leaders, complementary and value-based pricing), the conditions that suit each, and how to compare skimming with penetration using contribution and present value. It builds on the earlier topic on cost-based pricing. The next topic covers make-or-buy and outsourcing decisions.

The main market-based strategies

Market skimming

A high price at launch, aimed at buyers who want the product first and will pay for it, followed by cuts as the market widens and competitors arrive. It takes the best of the demand curve in layers. It suits when:

• the product is new and different, so buyers pay for the status of having it early;
• the life cycle is short, so development cost must be recovered quickly;
• early cash inflows are needed to cover large development costs;
• barriers to entry such as patents, high investment or strong brand loyalty keep rivals out; and
• demand and its sensitivity to price are uncertain: starting high and falling is safer than starting low and trying to rise.

Its risks are slow growth in share, the attraction of rivals by the high margins, and resentment from early buyers when the price falls.

Penetration pricing

A low price at launch to win a large share quickly, and to discourage rivals. It suits when demand is elastic, when there are economies of scale so that unit cost falls as volume rises, when the product is not very different from rivals’, and when a large customer base has later value (for other products or for repeat purchases).

Its risks are low early margins, the difficulty of raising the price later, and a price war.

Parity pricing and the going rate

The company prices at about the level of its competitors, usually when products are similar and one firm leads the market. It avoids price wars and competes on quality, service and brand. It needs a good view of costs, because the price is not chosen to cover them.

Price discrimination

The same or similar product is sold at different prices to different segments, by time, place, customer type or quantity: peak and off-peak, business and economy, student and adult. It raises contribution when the segments have different elasticities, the company can keep them apart so that low-price buyers cannot resell to high-price ones. The cost of separating them is small.

Buyers with inelastic demand pay more; those with elastic demand are attracted by lower prices.

Other approaches

• Loss leader. One product is sold below cost to bring customers in, to buy others at a profit. It works only if the other sales more than cover the loss.
• Complementary or captive pricing. The base product is cheap and the necessary consumables are dear: printers and ink, razors and blades.
• Premium pricing. A high price to signal quality, for brands with a reputation.
• Value-based pricing. The price is set by the customer’s perceived value, not by cost.
• Bundling and promotional pricing, and target pricing, where the market price sets the target cost.

Choosing and testing a strategy

A recommendation should rest on the facts of the case. Ask:

• What stage of the life cycle? Skimming at launch; falling prices in growth; stable in maturity.
• How uncertain and how elastic is demand? Elastic demand favours lower prices; uncertain demand favours starting high.
• Are there barriers to entry? Without them a high price invites rivals and skimming does not last.
• What does the company need? Cash to recover development cost, share, or survival.
• What are the capacity and cost conditions? If capacity is limited in the first year, as with a car that takes time to build, a high initial price rations demand and avoids the damage of a waiting list and late delivery.
• What will competitors do? A low price may start a price war.

Numbers help to compare strategies. Calculate contribution each period (price − variable cost) × volume, total it, and if cash timing matters, discount it. A strategy that gives a higher total may give a lower present value if the cash comes later. The result is only as good as the volume forecasts, so state the assumptions and test them.

A pricing strategy also changes over time. A common path is a skimming price at launch, reduced in growth to broaden the market and discourage entry, then steady in maturity. A company with a short-lived product should plan the whole price path at the start.

Strategies that go with differentiation, cost leadership, product lines and volume

• Skimming with differentiation. Skimming is hard once rivals have a similar product, because buyers already know what to expect to pay. It can still work if the new product is differentiated, usually on quality: high-quality cars cost more to make and sell in smaller numbers, but a high price gives a high contribution on each. Skimming is a short-term policy, because new entrants force prices down later.
• Penetration with cost leadership. A cost leadership strategy aims to be the lowest-cost producer, normally through large volumes and economies of scale. Penetration pricing fits it, because low prices win share, share brings volume, and volume lowers unit cost. It can also be used to launch a new brand into an established market.
• Complementary products. Where products are bought together (consoles and games, phones and calls) one may be sold cheaply to build demand for the other, which carries the larger margin.
• Product line pricing. A line of related items seen as one family (a tableware range, a sports brand) is often priced as a whole, for example as a high-price, high-quality range, so that the prices of the items are consistent with each other and with the brand.
• Volume discounting. A lower price for large orders or large purchases over a period. Its purpose is either to persuade customers to buy, on condition that the order is above a stated size, or to raise profit by selling larger volumes at a lower price.
• Price discrimination. The segments must be kept apart. Common bases are geography (the same product at very different prices in different countries), time (peak and off-peak, day of the week) and age group (student, adult, child or senior prices).

Comparing strategies in numbers

1. Contribution per unit. Price − variable cost, for each year and strategy.
2. Contribution for the year. Per unit × volume.
3. Total over the life. Add the years.
4. Present value. Each year’s contribution ÷ (1 + r)ⁿ, where n is the year, if timing matters.
5. Price discrimination. Revenue and contribution under one price, and under separate prices, and the difference.

Money is in naira, present values in ₦ million to two decimal places, and each answer is rounded once, at the end.

Worked examples

1. Skimming.
   Year 1 (1,200 − 400) × 5,000 = ₦4.0m.
   Year 2 (900 − 400) × 12,000 = ₦6.0m.
   Year 3 (700 − 400) × 20,000 = ₦6.0m.
   Total ₦16.0m.
2. Penetration.
   Unit contribution 300 each year: 300 × 20,000 = ₦6.0m
   300 × 28,000 = ₦8.4m
   300 × 30,000 = ₦9.0m.
   Total ₦23.4m.
3. Present values at 15%.
   Skimming 4.0 ÷ 1.15 + 6.0 ÷ 1.3225 + 6.0 ÷ 1.5209 = 3.48 + 4.54 + 3.94 = ₦11.96m.
   Penetration 6.0 ÷ 1.15 + 8.4 ÷ 1.3225 + 9.0 ÷ 1.5209 = 5.22 + 6.35 + 5.92 = ₦17.49m.
4. View. On these volumes penetration is better on both measures, because the large volume more than makes up for the lower unit margin. The conclusion depends on the volumes: if penetration volumes were much lower, or rivals entered at once and cut the price, the answer could reverse. The company should test the volume forecasts and consider barriers to entry before choosing.

1. Single price.
   Units 2,500; revenue ₦40,000 × 2,500 = ₦100.0m; contribution 30,000 × 2,500 = ₦75.0m.
2. Two prices.
   Business 52,000 × 550 = ₦28.6m; leisure 30,000 × 2,900 = ₦87.0m; revenue ₦115.6m.
3. Contribution.
   Business (52,000 − 10,000) × 550 = ₦23.1m; leisure (30,000 − 10,000) × 2,900 = ₦58.0m; total ₦81.1m.
4. Gain.
   81.1 − 75.0 = ₦6.1m.
5. Conditions. The gain holds only if business travellers cannot buy the cheap leisure tickets, for example by restricting those tickets to off-peak times or to those who book early.

Expect variants: a case that asks which strategy to recommend with no numbers, a launch price with limited capacity, or a question that asks for the price path over the life cycle.

Common mistakes

• Naming a strategy without the conditions. Show why the case fits.
• Confusing skimming with premium pricing. Skimming falls over time.
• Comparing prices instead of contribution. A higher price may give less total contribution.
• Ignoring timing. Discount if the cash comes in different years.
• Forgetting the risks, such as rivals entering a skimmed market or a price war after penetration.
• Assuming discrimination is always possible. It needs separable segments.

Quick revision

• Skimming: high then falling; new product, short life, cash need, entry barriers, uncertain demand.
• Penetration: low to win share; elastic demand, scale economies, deter rivals; price hard to raise.
• Parity: match rivals. Discrimination: segments with different elasticities that can be kept apart.
• Loss leader, captive pricing, value-based pricing.
• Compare on contribution and present value.

How the marks are earned

• Name and describe: each strategy, its conditions and a risk.
• Calculate: contribution per year, totals and present values.
• Recommend: apply to the facts and state the assumptions.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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