Price skimming is a strategy that businesses with strong brands commonly use to maximize profits by initially charging the highest possible price for an innovative new product and then gradually discounting the price over time to target (skim) more price-sensitive customer segments of the market. Done successfully, the business can quickly recoup the costs of bringing the new product to market before competition sets in. But is price skimming a good pricing strategy for your business?
Price Skimming in the Tech Industry
Price skimming is a routine practice in the technology industry where product lifespans are limited and upgrade cycles are short. Companies like Apple that have a very loyal customer base have the luxury of charging top prices for newly released products knowing that legions of the most fanatical Apple fans will purchase them regardless of cost. Prices are then gradually reduced over time as the product reaches the maturity stage.
For example, the Apple iPod classic was released in 2002 at a price of $399. In 2003 the price was reduced to $299, and then to $249 in 2005. As each new generation of iPod was released, the previous version was reduced in price.
Price Skimming Advantages
The main benefit to using a price skimming strategy is to more quickly recover the costs of the research and development (R&D) of new products. For example, the cost to develop a new prescription drug, including R&D, testing trials, and FDA approval, can exceed $2 billion.
Price skimming works well for companies that have a very strong brand and a reputation for quality. Loyal, well-heeled, status conscious consumers are often happy to be early adopters of products from companies such as Porsche or Mercedes for instance, regardless of price.
Price Skimming Disadvantages
New products that are expensively priced and heavily marketed as "innovative" raise high expectations among consumers and if the product does not live up to the hype the high initial price can quickly become a drag on sales and potentially a stain on the brand. For instance, Google Glass was introduced to the market with great fanfare and a whopping $1,500 price tag but became one of the worst product flops ever as users discovered that it was aesthetically unappealing and had no clear purpose.
High initial pricing also adds encouragement to competitors to ramp up their product releases to gain or retain market share—witness Apple and Samsung who are constantly leap-frogging each other with new releases of mobile phones and tablets.
The strategy of constantly price skimming new products can also become less effective over time as consumers become attuned to the practice and less amenable to paying top dollar for a product that they know they can buy in a few months for a reduced price.
Is Price Skimming Legal?
Price skimming by itself is not illegal, but can be construed as unethical in certain cases. Pharmaceutical companies are often accused of price gouging on lifesaving or other important drugs that are brought to market and sold at exorbitant prices until the patents expire, after which the prices are greatly reduced when competition enters the marketplace. Governments in the U.S. and elsewhere have frequently threatened to crack down on pharmaceutical industry pricing practices.
Companies that too quickly apply heavy price discounts can also raise the ire of customers and trigger a public relations backlash, as Apple did in 2007 by reducing the price of the iPhone by 33 percent just two months after the initial product release.
Alternative Pricing Strategies
Reverse Price Skimming: Airlines often utilize reverse price skimming by initially advertising a limited number of seats at an low price, then raising the price incrementally as more seats are taken and the flight eventually becomes fully booked (in practice this is even more complex, as airlines use sophisticated software to dynamically adjust their prices in real time to maintain high capacity utilization and maximize revenues).
Penetration Pricing: To break into a highly competitive and price sensitive market businesses often use penetration pricing—setting an initial low price for a product or service to quickly gain attention to your business and build a customer base. Telephone and internet service providers typically use this strategy by offering low initial prices to entice customers to switch from competitors. Credit card companies do the same by offering low initial interest rates to new customers.
Bundle Pricing: Businesses often discount bundled groups of products or products with services to attract customers. For example, phone companies will typically bundle internet service with a phone subscription at a lower price than the individual cost of each service. Software manufacturers tend to bundle applications that share features into suites (such as the Microsoft Office suite of products).