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Price skimming

Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. It is a temporal version of price discrimination/yield management.

Price Skimming

It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price.

Price skimming is sometimes referred to as riding down the demand curve. This can be seen the the series of diagrams on the right.The first diagram shows the demand schedule, price, and quantity demanded at time t=1.

Additional short run demand schedules representing times t=2 and t=3 are added in subsequent diagrams.

As time goes by, price decreases and volume increases.

When the 3 equilibria are joined we obtain the price skimmersí long run demand schedule (shown in green).

The objective of a price skimming strategy is to capture the consumer surplus (the area in blue, between the single market clearing price (P*) and the highest price charged (P1)). If this is done successfully, then theoretically no customer will pay less for the product than the maximum they are willing to pay. In practice it is impossible for a firm to capture all of this surplus.

Limitations of Price Skimming There are several potential problems with this strategy.

  • Firstly, it is only effective when the firm is facing an inelastic demand curve. If the long run demand schedule is elastic (as in the diagram below), market equilibrium will be achieved by quantity changes rather than price changes. Penetration pricing is a more suitable strategy in this case.

    Elastic Demand
Price changes by any one firm will be matched by other firms resulting in a rapid growth in industry volume. Dominant market share will typically be obtained by a low cost producer that pursues a penetration strategy.

  • Secondly, a price skimmer must be careful with the law. Price discrimination is illegal in many jurisdictions, but yield management is not. Price skimming can be considered either a form of price discrimination or a form of yield management. Price discrimination uses market characteristics (such as price elasticity) to adjust prices, whereas yield management uses product characteristics. Marketers see this legal distinction as quaint since in almost all cases market characteristics correlate highly with product characteristics. If using a skimming strategy, a marketer must speak and think in terms of product characteristics in order to stay on the right side of the law.
  • Thirdly, the inventory turn rate can be very low for skimmed products. This could cause problems for your distribution chain. It may be necessary to give retailers higher margins to convince them to enthusiasticlly handle your product.
  • Fourth, skimming encourages the entry of competitors. When other firms see the high margins available in the industry, they will quickly enter.
  • Fifth, skimming results in a slow rate of diffusion and adaption. This results in a high level of untapped demand. This gives competitors time to either imitate the product or leap frog it with a new innovation. If competitors do this, you will have lost your window of opportunity.
  • Sixth, you could develop negative publicity if you lower the price too fast and without significant product changes. Some early purchasers will feel they have been ripped-off. They will feel it would have been better to wait and purchase the product at a much lower price. This negative sentiment will be transferred to the brand and the company as a whole.
  • Seventh, high margins may make the firm inefficient. There will be no incentive to keep costs under control. Inefficient practices will become established making it difficult for you to compete on value or price.

See also : pricing, marketing, microeconomics, production, costs, and pricing, penetration pricing, price discrimination

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