Have you been out shopping, and when you finally walked out of the store realised that

you
had just exceeded your budget? You may have fallen into psychological pricing traps; it’s very
easily done.

Through various pricing strategies, stores are specifically designed to encourage you to spend
more than you intend.
The techniques that retail stores use can also be very effective when applied to pricing in other
industries. Let’s dive deeper into four of the most popular psychological pricing example
strategies that you can use to help increase your sales and, hopefully, avoid overspending at
the mall ever again.

Loss leader pricing and strategy is a marketing approach where a

product is intentionally sold at a loss or minimal profit to attract
customers. The marketing strategy is to entice shoppers with the
discounted item, hoping they will make additional purchases of higher-
margin products

What is loss-leader pricing?

Loss-leader pricing is when a company prices a popular item below its minimum
profit margin, sometimes below its cost, so that it can gain a larger overall profit
from other items customers buy. The leader is usually an item customers regularly
buy that helps draw them into the store. The goal is for people to buy the leader
and other items with much higher profit margins, either through store positioning,
advertising or the nature of the products.

Stores often heavily advertise loss leaders to attract customer attention. Some
businesses place loss leaders in the back of the store so shoppers pass many other
products to reach the sale items. They might also merchandise the loss leader on a
flashy display with accessories or other related products nearby to encourage
customers to purchase other higher-profit items.

Related: Break-Even Point: Definition, Variables and Examples

Loss-leader pricing examples
Loss-leader pricing is a popular strategy you can use to attract customers and
increase overall sales. Here are some examples of loss-leader pricing:

Gaming consoles

Gaming consoles are popular loss leaders, especially when they're new. They're
usually in high demand and have many high-profit items that customers buy with
them. When a store makes a gaming console a loss leader, some items it may
upsell to customers include:

 Video games
 Extra controllers
 Controller batteries
 Headsets
 Streaming equipment

Related: What Is Cost Leadership Strategy?

Grocery store items

Grocery stores use products like meat, eggs, bread and milk as loss leaders
because they're popular, essential products. Many people know what these items
typically cost, so they may be excited to save money on them. These are also
products that people usually buy with other items. For example, customers may
want vegetables to eat with meat, cereal to go with milk and sandwich fixings for
bread.

These products are typically in areas of the store that ensure shoppers pass other
items they may need. The store can also market items as part of a recipe, inspiring
shoppers to purchase other products. These kinds of items make good loss leaders
because they're perishable and likely to sell more quickly when they're on sale.
Related: A Complete Guide to Pricing Strategies

Hardware and tools

Large power tools make great loss leaders because they often have many
accessories that customers can buy with them. These extra items are often
impulse purchases and include storage cases, bits, stands and blades. Many
customers also buy other items they need for projects, like wood, stains and
gardening supplies.

Related: Product Categories: Classifying Consumer Goods

Printers

Printers are another example of loss-leader pricing because customers may feel
drawn to purchase other items that go with it. These products may include ink,
copy paper and stationery to use with them. A store can also market printers with
photo paper, other computer accessories and document or image editing
software.

Related: How To Calculate a Discount Using 2 Methods (With Examples)

Benefits of loss-leader pricing

Loss-leader pricing is a popular strategy in retail. Using loss-leader pricing can
benefit a company by helping it:

Attract customers
Some stores use loss-leader pricing to encourage customers to visit. Sale prices
attract customers, helping the store build a reputation for having great deals. They
can also use loss-leader pricing to sell items that are new to the market. Shoppers
are often more willing to try a new product when it's on sale.

Related: 10 Marketing Strategies To Attract and Retain Customers

Engage in cross-promotion

A store can use loss-leader pricing to promote other items it sells. If you're
responsible for merchandising, consider arranging attractive displays that feature
both loss leaders and higher-profit items. You could also shelve loss leaders next
to similar products that aren't on sale. For example, you could place a rack of fall
coats next to a display of loss-leader boots.

What is Price Lining?

Price lining (also product line pricing) is a marketing strategy where a business
prices its offerings according to the quality, features, or attributes to
differentiate it from other similar offerings.

In simple terms, price lining is a process of grouping similar offerings under

different price brackets – each varying slightly by the quality features, or
attributes on offer. These brackets usually tend to start low and go higher in
price.

Take Coca-Cola, for example. The company sells different sizes of the same
drink at different prices. It even prices the gift packs differently during festivals.

Price lining is a marketing strategy even though it has the term “price” in its
name. The main objective of this strategy is to make the offering appeal to a
wider range of customers and eventually boosting sales and audience numbers.
What is prestige pricing in marketing?
Prestige pricing is a pricing strategy that uses higher prices to suggest quality and exclusivity.
This practice is commonly seen among luxury brands and fine restaurants.

While establishing a higher price for your product can make it seem more exclusive and high
quality, if you don’t have anything special or unique about your product then this can backfire
by attracting fewer customers.
Does prestige pricing work?
The theory is that customers will pay higher prices for the right image and won’t investigate
whether the price accurately reflects the value. A prestige pricing strategy has the ability to
give companies a psychological marketing advantage by convincing customers there is added
value for the cost, and it takes advantage of the buyer’s assumption that one brand’s product is
of a higher quality than the competitors because it costs more.

Which brands make use of a prestige pricing

strategy?
There are many examples of companies and brands that use a prestige pricing strategy to
leverage their products. Luxury car companies are notorious for jacking up prices on high end
vehicles. A Toyota Camry or a Honda Civic will get you from point A to point B just as well
as a Bentley or a BMW, but customers who value driving around in fancy automobiles
probably wouldn’t tolerate driving an entry level sedan as their main mode of transportation.

A Rolex watch can cost well over ten grand depending on the amount of embedded bling, but
you can purchase a Timex watch with twice as many features for around $28 or less. They
both tell the time, but it’s obvious that the Rolex is a status symbol that appeals to their
customers because it displays their financial success in addition to the correct time. These
prestige pricing examples depict that value is in the brand, not the functionality of the product,
and you can’t blame companies for setting high prices to reinforce the perceived value they
offer their customers.
Prestige pricing strategy example: Nike
Nike is a perfect example of a company that effectively uses prestige pricing, which is a
pricing strategy where prices are set higher than normal because lower prices will actually hurt
sales. If customers value the image of your brand and the features of your product over those
of your competitors, then prestige pricing (also known as image pricing) can help you capture
value despite the production costs or quality of the product.
I used to pay top dollar for sneakers. If Nike put out a limited run of hi top Dunks in an
attractive colorway I was all over it, and more likely than not the amount I paid just to get my
hands on them was far beyond what they were worth. A similar pair of sneakers by a lesser
known brand might cost $30 less (I never pitched a tent in front of boutique shoe stores just to
wait all night for super expensive kicks), but I had to have that instantly recognizable Nike
swoosh on the side of my shoes or I wouldn’t feel satisfied.

So how could I shell out so much cash for premium sneakers? After all, they didn’t even fit my
humongous feet (size 13 wide, it’s a curse). My only explanation is that I valued the Nike
brand more than the actual functionality or quality of the product, and it didn’t matter how
expensive the shoes were. In fact I’m not sure I would have been quite as interested if the price
was lower.
How can I use prestige pricing?
Don’t worry, we know most of you aren’t marketing or selling hot kicks. Prestige pricing is
used by businesses of all types to appeal to customers’ sense of value and increase profits, and
you don’t have to be the proprietor of a legendary brand to use this strategy effectively. There
are great ways to use high prices as a guide towards more realistic sales as well as a method for
communicating value. Let’s take a look at a few of the tricks.

1. Create an enterprise tier (whether you have an enterprise

product or not)
One way your business can use prestige pricing is to create an expensive enterprise tier on your
pricing page, even if it isn’t real! Eric has discussed this strategy of price anchoring before,
and it’s an effective way to increase the perceived value of your offering and your revenue
stream.

For example, if you’re selling a SaaS product that costs $50 per month, you can create an
enterprise tier that costs $300 per month with a few additional features like more storage or
unlimited users. The enterprise tier will be out of reach for most of your potential buyers, but it
will serve as an anchor that guides them to the $50 product. Just remember to include the right
features in the target product so that it’s an ideal purchase for your customers as well as your
business. In this case, the enterprise tier is there to persuade customers the $50 tier is a great
deal, and shouldn’t bear any superior features that your prospects will be attracted to but
unable to afford.

2. Create prestigious image for your brand (and the right

environment)

A crucial factor in reinforcing higher prices is creating a prestigious image for your company
from the ground up. If you can improve the customer experience with the right environment
and consistent, great service, then your company will convey an image that proves your
product is a great value at a higher price than your competitors.

Building your product value is essential before you consider offering a prestige pricing plan, as
you’ll need to secure considerable buy-in from customers. The key is to be consistent with
what you promise to your customers. Charging higher rates won’t succeed unless you deliver
the goods based on your core value proposition and a clear message. That being said, it doesn’t
hurt to look the part if your target customers are high rollers, and if your office has upscale
furniture and a swanky conference room (maybe a nice bar too), your clients will leave with a
lasting impression of luxury and sophistication. Your website team photos can incorporate the
same tactics. If every team member is dressed in fine suits, either for individual or group
photos, your company will look professional and experienced to potential customers. This can
also work especially well if you have an outbound sales team pushing high end products to
vendors and distributors. Combine this apparent luxury image with great customer service, and
justifying those prestige prices will be that much easier.
3. Give your price the right image
The actual appearance of your published prices can have subconscious effects on your
potential customers that increase sales. In some cases, smaller details like ending your prices in
0’s or 5’s and avoiding decimal pricing can justify a higher price by presenting an image of
higher quality. This type of psychological pricing strategy is used in high end restaurants all
the time, and you rarely see a price like “8.99” for a meal unless you’re in a chain or franchise
establishment. Prices ending in 9 are meant to persuade consumers they’re getting a bargain,
but prices consisting of round numbers (no cents, no decimals) can subliminally convince
customers that your company has integrity and your product is sophisticated. In other words,
it’s worth the high price they pay.

The design of your pricing page can also create the right image for your prices and increase
perceived value. One company that optimized their pricing in this way is Survey Monkey,
which offers a comprehensive software survey tool.

Their pricing page advertises the $25 per month Gold tier as the most popular, and used color
differentiation and a slightly larger pricing bracket for added emphasis (see our post on pricing
page design tactics). The Select tier below it has all but one of the features included in Gold,
but it’s priced $8 less at $17 per month. Despite the lack of feature differentiation, customers
are nonetheless attracted to the more expensive Gold version because it looks like the best
option. The Gold bracket’s perceived value is further increased by a $65 per month option
positioned to its right that serves as a price anchor. Most customers would probably be satisfied
with the Select option, but the key design elements and the price anchor help SurveyMonkey
persuade customers to go for Gold.
Prestige pricing: Consistency is key
The keys to maintaining both credibility and higher margins are the same: be consistent and
avoid discounts that hurt the bottom line. The software space is no place for slashing prices to
make quick conversions; doing so will lead to an undervalued product and poor future sales.
(For more on discounts, see our post How Discounting is Killing Your Pricing Strategy).
Build trust and forge customer relationships with optimal prices that reflect the work you’ve
put into the business, and you’ll soon overwhelm the competition.
To learn more about pricing specifics, check out our Pricing Strategy ebook, our Pricing
Page Bootcamp, or learn more about our price optimization software. We're here to help!

What Is Marginal Cost?

In economics, the marginal cost is the change in total production cost that
comes from making or producing one additional unit. To calculate marginal
cost, divide the change in production costs by the change in quantity. The
purpose of analyzing marginal cost is to determine at what point an
organization can achieve economies of scale to optimize production and overall
operations. If the marginal cost of producing one additional unit is lower than
the per-unit price, the producer has the potential to gain a profit.

Marginal Cost Formula

Marginal cost is calculated as the total expenses required to manufacture one
additional good. Therefore, it can be measured by changes to what expenses
are incurred for any given additional unit.

Marginal Cost = Change in Total Expenses / Change in Quantity of Units

Produced

The change in total expenses is the difference between the cost of

manufacturing at one level and the cost of manufacturing at another. For
example, management may be incurring $1,000,000 in its current process.
Should management increase production and costs increase to $1,050,000,
the change in total expenses is $50,000 ($1,050,000 - $1,000,000).

he change in quantity of units is the difference between the number of units

produced at two varying levels of production. Marginal cost strives to be
based on a per-unit assumption, so the formula should be used when it is
possible to a single unit as possible.1 For example, the company above
manufactured 24 pieces of heavy machinery for $1,000,000. The increased
production will yield 25 total units, so the change in quantity of units produced
is one (25 - 24).
The formula above can be used when more than one additional unit is being
manufactured. However, management must be mindful that groups of
production units may have materially varying levels of marginal cost.

Understanding Marginal Cost

Marginal cost is an economics and managerial accounting concept most
often used among manufacturers as a means of isolating an optimum
production level. Manufacturers often examine the cost of adding one more
unit to their production schedules.

At a certain level of production, the benefit of producing one additional unit

and generating revenue from that item will bring the overall cost of producing
the product line down. The key to optimizing manufacturing costs is to find
that point or level as quickly as possible.

Marginal cost includes all of the costs that vary with that level of production.
For example, if a company needs to build an entirely new factory in order to
produce more goods, the cost of building the factory is a marginal cost. The
amount of marginal cost varies according to the volume of the good being
produced.

Marginal cost is an important factor in economic theory because a company

that is looking to maximize its profits will produce up to the point where
marginal cost (MC) equals marginal revenue (MR). Beyond that point, the
cost of producing an additional unit will exceed the revenue generated.

What Is Predatory Pricing?

Predatory pricing is the illegal business practice of setting prices for a product
unrealistically low in order to eliminate the competition.

Predatory pricing violates antitrust laws, as its goal is to create a monopoly.

However, the practice can be difficult to prosecute. Defendants may argue
that lowering prices is a normal business practice in a competitive market
rather than a deliberate attempt to undermine the marketplace.

Predatory pricing doesn’t always work, since the predator is losing revenue
as well as the competition. The predator must raise prices eventually. At that
point, new competitors will emerge.
Understanding Predatory Pricing
To understand how predatory pricing affects markets, and eventually
consumers, it is necessary to take a longer view.

Consumers enjoy the short-term benefits of competitive pricing. Heightened

competition creates a buyer’s market in which the consumer enjoys lower
prices, increased leverage, and wider choice.

However, if one company cuts its prices unrealistically low or even below
cost, others competitors will be forced to abandon the market. At that point,
the advantages for consumers quickly evaporate—or even reverse.

A monopolistic marketplace allows a single producer to raise prices, safe in

the knowledge that the consumer has no alternatives.

The Effects of Predatory Pricing

Luckily for consumers, predatory pricing practices tend to backfire in the long
run. In order to drive all rivals out of a business, the predator must cut prices
below their manufacturing costs. The intent, of course, is to raise prices back
to normal or above normal once the competition is gone.

Pricing Approaches
Companies can choose many ways to set their prices. We’ll examine some
common methods you often see. Many stores use cost-plus pricing, in which they
take the cost of the product and then add a profit to determine a price. Cost-plus
pricing is very common. The strategy helps ensure that a company’s products’
costs are covered and the firm earns a certain amount of profit. When companies
add a markup, or an amount added to the cost of a product, they are using a form of
cost-plus pricing. When products go on sale, companies mark down the prices, but
they usually still make a profit. Potential markdowns or price reductions should be
considered when deciding on a starting price.

Many pricing approaches have a psychological appeal. Odd-even pricing occurs

when a company prices a product a few cents or a few dollars below the next dollar
amount. For example, instead of being priced $10.00, a product will be priced at
$9.99. Likewise, a $20,000 automobile might be priced at $19,998, although the
product will cost more once taxes and other fees are added. See Figure 15.4 for an
example of odd-even pricing.

Figure 15.4

The charcoal shown in the photo is priced at $5.99 a bag, which is an example of odd-even pricing, or pricing a product slightly
below the next dollar amount.
Mike Mozart – Kingsford, Charcoal – CC BY 2.0.

Prestige pricing occurs when a higher price is utilized to give an offering a high-
quality image. Some stores have a quality image, and people perceive that perhaps
the products from those stores are of higher quality. Many times, two different
stores carry the same product, but one store prices it higher because of the store’s
perceived higher image. Neckties are often priced using a strategy known as price
lining, or price levels. In other words, there may be only a few price levels ($25,
$50, and $75) for the ties, but a large assortment of them at each level. Movies and
music often use price lining. You may see a lot of movies and CDs for $15.99,
$9.99, and perhaps $4.99, but you won’t see a lot of different price levels.

Remember when you were in elementary school and many students bought
teachers little gifts before the holidays or on the last day of school. Typically,
parents set an amount such as $5 or $10 for a teacher’s gift. Knowing that people
have certain maximum levels that they are willing to pay for gifts, some companies
use demand backward pricing. They start with the price demanded by consumers
(what they want to pay) and create offerings at that price. If you shop before the
holidays, you might see a table of different products being sold for $5 (mugs,
picture frames, ornaments) and another table of products being sold for $10 (mugs
with chocolate, decorative trays, and so forth). Similarly, people have certain
prices they are willing to pay for wedding gifts—say, $25, $50, $75, or $100—so
stores set up displays of gifts sold at these different price levels. IKEA also sets a
price for a product—which is what the company believes consumers want to pay
for it—and then, working backward from the price, designs the product.

Leader pricing involves pricing one or more items low to get people into a store.
The products with low prices are often on the front page of store ads and “lead” the
promotion. For example, prior to Thanksgiving, grocery stores advertise turkeys
and cranberry sauce at very low prices. The goal is to get shoppers to buy many
more items in addition to the low-priced items. Leader or low prices are legal;
however, as you learned earlier, loss leaders, or items priced below cost in an effort
to get people into stores, are illegal in many states.

Sealed bid pricing is the process of offering to buy or sell products at prices
designated in sealed bids. Companies must submit their bids by a certain time. The
bids are later reviewed all at once, and the most desirable one is chosen. Sealed
bids can occur on either the supplier or the buyer side. Via sealed bids, oil
companies bid on tracts of land for potential drilling purposes, and the highest
bidder is awarded the right to drill on the land. Similarly, consumers sometimes bid
on lots to build houses. The highest bidder gets the lot. On the supplier side,
contractors often bid on different jobs and the lowest bidder is awarded the job.
The government often makes purchases based on sealed bids. Projects funded by
stimulus money were awarded based on sealed bids.

Figure 15.5
 When people think of auctions, they may think of the words, “Going, going, gone.” Online auctions use a similar bidding
process.
Wikimedia Commons – CC BY-SA 3.0.

Bids are also being used online. Online auction sites such as eBay give customers
the chance to bid and negotiate prices with sellers until an acceptable price is
agreed upon. When a buyer lists what he or she wants to buy, sellers may submit
bids. This process is known as a forward auction. If the buyer not only lists what
he or she wants to buy but also states how much he or she is willing to pay,
a reverse auction occurs. The reverse auction is finished when at least one firm is
willing to accept the buyer’s price.

Going-rate pricing occurs when buyers pay the same price regardless of where they
buy the product or from whom. Going-rate pricing is often used on commodity
products such as wheat, gold, or silver. People perceive the individual products in
markets such as these to be largely the same. Consequently, there’s a “going” price
for the product that all sellers receive.

Price bundling occurs when different offerings are sold together at a price that’s
typically lower than the total price a customer would pay by buying each offering
separately. Combo meals and value meals sold at restaurants are an example.
Companies such as McDonald’s have promoted value meals for a long time in
many different markets. See the following video clips for promotions of value
meals in the United States, Greece, and Japan. Other products such as shampoo
and conditioner are sometimes bundled together. Automobile companies bundle
product options. For example, power locks and windows are often sold together,
regardless of whether customers want only one or the other. The idea behind
bundling is to increase an organization’s revenues.

Video Clip

McDonald’s Introduced Value Meals in 1985

(click to see video)

Look at the cost and the amount of food in the original value meal.

Video Clip

McDonald’s Uses Humor in Greece to Sell Big Macs

(click to see video)

Video Clip

McDonald’s in Japan

(click to see video)

McDonald’s is popular around the world.

Captive pricing is a strategy firms use when consumers must buy a given product
because they are at a certain event or location or they need a particular product
because no substitutes will work. Concessions at a sporting event or a movie
provide examples of how captive pricing is used. Maybe you didn’t pay much to
attend the game, but the snacks and drinks were extremely expensive. Similarly, if
you buy a razor and must purchase specific razor blades for it, you have
experienced captive pricing. The blades are often more expensive than the razor
because customers do not have the option of choosing blades from another
manufacturer.

Pricing products consumers use together (such as blades and razors) with different
profit margins is also part of product mix pricing. Recall from Chapter 6 “Creating
Offerings” that a product mix includes all the products a company offers. If you
want to buy an automobile, the base price might seem reasonable, but the options
such as floor mats might earn the seller a much higher profit margin. While
consumers can buy floor mats at stores like Walmart for $30, many people pay
almost $200 to get the floor mats that go with the car from the dealer.

Most students and young people have cell phones. Are you aware of how many
minutes you spend talking or texting and what it costs if you go over the limits of
your phone plan? Maybe not if your plan involves two-part pricing. Two-part
pricing means there are two different charges customers pay. In the case of a cell
phone, a customer might pay a charge for one service such as a thousand minutes,
and then pay a separate charge for each minute over one thousand. Get out your
cell phone and look at how many minutes you have used. Many people are shocked
at how many minutes they have used or the number of messages they have sent in
the last month.

Have you ever seen an ad for a special item only to find out it is much more
expensive than what you recalled seeing in the ad? A company might advertise a
price such as $25*, but when you read the fine print, the price is really five
payments of $25 for a total cost of $125. Payment pricing, or allowing customers
to pay for products in installments, is a strategy that helps customers break up their
payments into smaller amounts, which can make them more inclined to buy higher-
priced products.

Promotional pricing is a short-term tactic designed to get people into a store or to

purchase more of a product. Examples of promotional pricing include back-to-
school sales, rebates, extended warranties, and going-out-of-business sales.
Rebates are a great strategy for companies because consumers think they’re getting
a great deal. But as you learned in Chapter 12 “Public Relations, Social Media, and
Sponsorships”, many consumers forget to request the rebate. Extended warranties
have become popular for all types of products, including automobiles, appliances,
electronics, and even athletic shoes. If you buy a vacuum for $35, and it has a one-
year warranty from the manufacturer, does it really make sense to spend an
additional $15 to get another year’s warranty? However, when it comes to
automobiles, repairs can be expensive, so an extended warranty often pays for
itself following one repair. Buyers must look at the costs and benefits and
determine if the extended warranty provides value.

We discussed price discrimination, or charging different customers different prices

for the same product, earlier in the chapter. In some situations, price discrimination
is legal. As we explained, you have probably noticed that certain customer groups
(students, children, and senior citizens, for example) are sometimes offered
discounts at restaurants and events. However, the discounts must be offered to all
senior citizens or all children within a certain age range, not just a few. Price
discrimination is used to get more people to use a product or service. Similarly, a
company might lower its prices in order to get more customers to buy an offering
when business is slow. Matinees are often cheaper than movies at night; bowling
might be less expensive during nonleague times, and so forth.

Price Adjustments
Organizations must also decide what their policies are when it comes to
making price adjustments, or changing the listed prices of their products. Some
common price adjustments include quantity discounts, which involves giving
customers discounts for larger purchases. Discounts for paying cash for large
purchases and seasonal discounts to get rid of inventory and holiday items are
other examples of price adjustments.

A company’s price adjustment policies also need to outline the firm’s shipping
charges. Many online merchants offer free shipping on certain products, orders
over a certain amount, or purchases made in a given time frame. FOB (free on
board) origin and FOB delivered are two common pricing adjustments businesses
use to show when the title to a product changes along with who pays the shipping
charges. FOB (free on board) origin means the title changes at the origin—that is,
when the product is purchased—and the buyer pays the shipping charges. FOB
(free on board) destination means the title changes at the destination—that is, after
the product is transported—and the seller pays the shipping charges.

Uniform-delivered pricing, also called postage-stamp pricing, means buyers pay

the same shipping charges regardless of where they are located. If you mail a letter
across town, the postage is the same as when you mail a letter to a different state.

Recall that we discussed trade allowances in Chapter 12 “Public Relations, Social

Media, and Sponsorships”. For example, a manufacturer might give a retail store
an advertising allowance to advertise the manufacturer’s products in local
newspapers. Similarly, a manufacturer might offer a store a discount to restock the
manufacturer’s products on store shelves rather than having its own representatives
restock the items.

Reciprocal agreements are agreements in which merchants agree to promote each

other to customers. Customers who patronize a particular retailer might get a
discount card to use at a certain restaurant, and customers who go to a restaurant
might get a discount card to use at a specific retailer. For example, when customers
make a purchase at Diesel, Inc., they get a discount coupon good to use at a certain
resort. When customers are at the resort, they get a discount coupon to use at
Diesel. Old Navy and Great Clips implemented similar reciprocal agreements.

A promotion that’s popular during weak economic times is called a bounce back.
A bounce back is a promotion in which a seller gives customers discount cards or
coupons (see Figure 15.6) after purchasing. Consumers can then use the cards and
coupons on their next shopping visits. The idea is to get the customers to return to
the store or online outlets later and purchase additional items. Some stores set
minimum amounts that consumers have to spend to use the bounce back card.

What is Price Skimming?

Price skimming, also known as skim pricing, is a pricing strategy in which a
firm charges a high initial price and then gradually lowers the price to
attract more price-sensitive customers. The pricing strategy is usually used
by a first mover who faces little to no competition. Price skimming is not a
viable long-term pricing strategy, as competitors eventually launch rival
products and put pricing pressure on the first company.
Rationale Behind Price Skimming

Price skimming is used to maximize profits when a new product or service

is deployed. Therefore, the pricing strategy is largely effective with a
breakthrough product, where the firm is the first to enter the
marketplace. In such a strategy, the goal is to generate the maximum
profit in the shortest time possible, rather than to generate maximum
sales. This enables a firm to quickly recover its sunk costs before
increased competition and pricing pressure arise.

Consider the diffusion of innovation, a theory that explains the rate at

which a product spreads throughout a social system. Innovators are those
who want to be the first to get a new product or service. They are risk-
takers and price insensitive. A price skimming strategy tries to get the
highest possible profit from innovators and early adopters. As the
demand from these two consumer segments fills up, the price of the
product is reduced, to target more price-sensitive customers such as early
majorities and late majorities.

Illustration and Example of Price Skimming

Company A is a phone manufacturing company that recently developed a

new proprietary technology for its phones. Company A follows a price
skimming strategy and sets a skim price at P1 to recover its research and
development cost. After satisfying demand at P1, the company sets a
follow-on price at P2 to capture price-sensitive customers and to put
pricing pressure on competitors that enter the market.

In the price skimming strategy above, Company A generates revenue = A +

B with sales of Q1. With their follow-on pricing, the company generates
additional revenue = C with sales of Q2-Q1. The company generates total
revenue of A + B + C, with total sales of Q2.
Advantages of Price Skimming

 Perceived quality: Price skimming helps build a high-quality image

and perception of the product.
 Cost recuperation: It helps a firm quickly recover its costs of
development.
 High profitability: It generates a high profit margin for the
company.
 Vertical supply chain benefits: It helps distributors earn a higher
percentage. The markup on a $500 product is far more substantial
than on a $5 item.

Disadvantages

 Deterrence: If the firm is unable to justify its high price, then

consumers may not be willing to purchase the product.
 Limitation of sales volume: A firm may not be able to
utilize economies of scale if a skim price generates too few sales.
 Inefficient long-term strategy: Price skimming is not a viable long-
term pricing strategy, as competitors will eventually enter the
market with rival products and exert downward pricing pressure.
 Consumer loyalty: If a product that costs $1,000 at launch has a
follow-on price of $200 in a couple of months, innovators and early
adopters may feel ripped off. Therefore, if the firm has a history of
price skimming, consumers may wait a couple of months before
purchasing the product.

What is Penetration Pricing?

Penetration pricing is a pricing strategy that is used to quickly gain market
share by setting an initially low price to entice customers to purchase. This
pricing strategy is generally used by new entrants into a market. An
extreme form of penetration pricing is called predatory pricing.
Rationale Behind Penetration Pricing

It is common for a new entrant to use a penetration pricing strategy to

quickly obtain a substantial amount of market share. Price is one of the
easiest ways to differentiate new entrants from existing market players.
The overarching goal of this pricing strategy is to:

 Capture market share

 Create brand loyalty
 Switch customers from competitors
 Generate significant demand, looking to utilize economies of scale
 Drive competitors out of the market

Situations where penetration pricing works effectively:

 When there is little product differentiation

  Demand is price-elastic
 Where the product is suitable for a mass market (and, therefore, for
utilizing economies of scale)

Illustration and Example of Penetration Pricing

A current small-sized player in the marketplace where laundry detergent

sells at around $15. Company A is an international company with a large
amount of excess production capacity and is, therefore, able to produce
laundry detergents at a significantly lower cost.

Company A decides to enter the market, employ a penetration pricing

strategy, and sell laundry detergent at a sale price of $6.05. The company’s
cost to produce laundry detergent is $6.

With a marginal cost of $6 and a sale price of $6.05, Company A is making

nominal profits per sale. However, the company is comfortable with this
decision as its overarching goal is to switch customers over, capture as
much market share as possible, and utilize economies of scale with their
high production capacity.

Company A believes that its competitor will not be able to sustain itself in
the long-term and will eventually exit the market. When the competitor
exits the marketplace, Company A will become the only seller of laundry
detergent and therefore be able to establish a monopoly over the market
and raise prices to a level that will provide a high profit margin.

Advantages of Penetration Pricing

 High adoption and diffusion: Penetration pricing enables a

company to get its product or service quickly accepted and adopted
by customers.
 Marketplace dominance: Competitors are typically caught off
guard by a penetration pricing strategy and are afforded little time
to react. The company is able to utilize the opportunity to switch
over as many customers as possible.
 Economies of scale: The pricing strategy generates a high sales
quantity that enables a firm to realize economies of scale and lower
its marginal cost.
 Increased goodwill: Customers that are able to find a bargain in a
product or service are likely to return to the firm in the future. In
addition, this increased goodwill creates positive word of mouth.
 High inventory turnover: Penetration pricing results in an
increased inventory turnover rate, making vertical supply chain
partners, such as retailers and distributors, happy.

Disadvantages of Penetration Pricing

 Pricing expectation: When a firm uses a penetration pricing

strategy, customers often expect permanently low prices. If prices
gradually increase, customers may become dissatisfied and may
stop purchasing the product or service.
 Low customer loyalty: Penetration pricing typically attracts bargain
hunters or those with low customer loyalty. Said customers are likely
 to switch to competitors if they find a better deal. Price cutting, while
effective for making some immediate sales, rarely engenders
customer loyalty.
 Damage brand image: Low prices may affect the brand image,
causing customers to perceive the brand as cheap or poor quality.
 Price war: A price penetration strategy may trigger a price war. This
decreases overall profitability in the market, and the only companies
strong enough to survive a protracted price war are usually not the
new entrant who triggered the war.
 Inefficient long-term strategy: Price penetration is not a viable
long-term pricing strategy. It is usually a better idea to approach the
marketplace with a pricing strategy that your company can live with,
long-term. While it may then take longer to acquire a sizeable
market share, such a patient, long-term strategy is more likely to
serve your company better overall, and less likely to expose you to
severe financial risks.