In the winter of 2005 I finally broke down and purchased an iPod, settling on the slimmed-down 30 GB iPod Photo priced at $349. For me, purchasing a product that was both expensive and easily lost was a hard decision to make, but I was tired of envying my friends who stored the bulk of their record collections on pocket-sized music players. I also felt it was a smart purchase considering just four months earlier a bulkier 40 GB iPod Photo was priced at $499, and the 30% price drop easily persuaded me to take the plunge.
photo credit: el patojo
However, in October of that same year Apple released an even slimmer 30 GB iPod that could play videos, priced at $299. I couldn’t help thinking that if I had held out, I could have not only saved $50 dollars on an iPod, but also play sweet videos on a tiny screen. Interestingly enough though, the feeling that I was missing out and regret was brief. I didn’t need to watch videos and my version of the music player was skinny enough to fit in my pocket.
I bore you with this story concerning my musical pursuits, because Apple consistently follows a pattern of releasing new versions of their products and price cuts. Customers who want the latest and greatest knowingly purchase at a higher price while knowing the price will probably drop in less than six months. Apple prices their innovative products higher during their initial release, because the company knows steeper prices won’t decrease customer demand for the latest gadgets, and they benefit from the higher short-term profit margins. Let's explore this concept, discussing the pros and cons to price skimming while explaining where the tactic fits into your pricing strategy.
What is Price Skimming?
Price skimming is the strategy of charging a relatively high price during the launch of a new, innovative product and then lowering the price over time to access different points on the demand curve.
How does Price Skimming Work?
Customers known as early adopters will pay steeper prices for a cutting edge product if it’s marketed as a “must have”, whether the price accurately reflects the value or not. Eventually, prices are lowered to follow the product demand curve and attract more price-sensitive customers. Theoretically, as each customer segment is “skimmed” off the top a company can capture some of the consumer surplus by charging the maximum price each segment is willing to pay.
“Theoretically” is the key word here, because although price skimming can effectively segment the market, it’s almost impossible for the strategy to capture all of the consumer surplus. Price skimming is most effective when the product follows an inelastic demand curve, meaning the quantity demanded doesn’t rise or fall drastically in response to a change in prices (for more on this, see our post on price elasticity). While necessities like gasoline and electricity are almost always inelastic, state-of-the-art products like the iPhone can potentially walk the same path. Let’s uncover the pros and cons of price skimming before exploring the market characteristics that make the strategy a viable tactic for your business.
Pros of Price Skimming
1. Higher Return on Investment
Charging more during the launch of an innovative product, particularly in high tech industries, can help your company recoup research and development costs as well as promotional expenses. Companies like Apple benefit from high short term profits during a product’s introduction, and the initial higher prices are justified by the technological breakthroughs they achieve.
The bottom line is, if you invested all of your cash flow and resources into the development of a gadget or service no competitor can match, then you should be able to charge higher prices during the launch to recover the bulk of your investment and hopefully fund further developments.
2. It Helps Create and Maintain Your Brand Image
Price skimming can also create the perception that a product is a high quality “must have” for those early adopters who can’t live without the latest tech products. Higher prices in the beginning of a product’s life cycle enable you to build a prestigious brand image that actually attracts status conscious consumers, and in addition, you’ll have the breathing room you need to lower prices as competitors enter the market. In some cases a lower starting price in the beginning can also increase customer price sensitivity, making it impossible to raise rates in the future without losing sales.
photo credit: Hans Olofsson
3. It Segments the Market
As discussed before, price skimming is an effective way to segment your customer base, potentially allowing you to earn the greatest possible profits from different types of customers as you reduce the price. Starting with a higher price won’t deter your early adopters, and as you lower the price over time you’ll attract more price sensitive consumers. If you alter prices based on the product demand curve and the maximum price the customers are willing to pay, you can capture some of that consumer surplus and rake in more revenue.
4. Early Adopters Help Test New Products
One benefit of early adopter customers is they act as guinea pigs for new products. Those status conscious consumers that purchase your innovative product first can provide valuable feedback and help you work out the kinks before the next update and foreseeably a wider user base. In addition to being valuable testers, early adopters who love your product can act as brand evangelists that create a perception of quality via word of mouth. This free promotion will persuade new customers to buy the product when the price drops.
photo credit: x-ray delta one
Cons of Price Skimming
1. It Only Works if Your Demand Curve is Inelastic
Price skimming might be a viable tactic for Apple, but that’s because the quantity demanded doesn’t rise and fall dramatically when the prices change. If the demand curve for your product is generally elastic, meaning price changes have a greater effect on product demand, then initial high prices could really hurt your sales. The goal of any company is to make a product as inelastic as possible, but not everyone is selling tech products or services that are ingenious enough to appear indispensable to consumers.
2. It’s Not a Great Strategy in a Crowded Market
In any industry, assessing customer valuations and analyzing the competition prior to setting your prices is crucial. If you already have a lot of competitors then chances are your demand curve is fairly elastic, and high prices during your product launch will send customers running in the other direction. Price skimming is not a viable strategy in an already busy market, so unless your product includes amazing new features no one can match, it might be a good idea to avoid skimming if fierce competition already exists.
photo credit: pangalactic gargleblaster and the heart of gold
3. Skimming Attracts Competitors
Maybe your product is ground breaking enough that it will create a new market, but as shown by the introductions of the iPhone and the iPad, competitors like Samsung and Microsoft are lurking just around the corner. The success of high prices in the beginning of a new product’s life cycle will intrigue competitors to enter the market, and the inelasticity of a demand curve is almost always reduced over time due to the introduction of viable substitutes. Price skimming can also slow the rate of adoption by your potential customers, giving the competition more time to imitate and improve upon your product before you’ve capitalized on the demand for the innovation.
4. It Can Infuriate Your Early Adopters
Remember those brand evangelists that bought your product first? They can just as easily trigger your worst PR nightmare. If prices drop too much or too soon after the initial product launch, your early adopters will feel like they got the short end of the stick. Apple experienced this type of backlash in 2007 when the company reduced the price of the iPhone by $200 dollars just two months after its introduction. The quick 33% price drop from $599 to $399 may have helped increase demand, but some of the phone’s early adopters were understandably upset.
photo credit: RLHyde
To ensure the customers at the top of your demand curve don’t feel cheated, it’s important to use price skimming in a consistent manner and avoid hurried or blatantly obvious reductions in price. Price skimming can also be considered price discrimination, which is the strategy of selling the same product at different prices to different groups of consumers. In some cases this strategy is against the law, but the actual conditions that define illegal price discrimination are shady to say the least. For more on the ethical issues of price discrimination, check out our post on pricing strategy ethics.
Summary: Understand Your Market Before Using Price Skimming
After analyzing the pros and cons, we can see that price skimming is a notable method for pricing an innovative new product, provided that you’re wary of the pitfalls. Be cautious when setting high initial prices and reducing them over time, as the wrong move or quick price drops can elicit that dreaded PR backlash. Analyzing and understanding what customers value with regard to your offering will help you uncover the true nature of the demand curve, as well as the viability of implementing a price skimming strategy. As long as there are few competitors in the market and you communicate the price reductions effectively, skimming can bring in the revenue you need to quickly recoup development costs, continue updating the product, and ensure the survival of your business.