A price-skimming strategy works well when introducing

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.

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 on an iPod but also played 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 price points 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 of price skimming while explaining where the tactic fits into your pricing strategy. 

What is Price Skimming?

Price skimming is a pricing strategy where the price of goods or services is set high at the time of launch and then lowered as consumers become more familiar with it. This method targets early adopters and does not target the mass market.

A variant of this strategy is called penetration pricing, which sets high launch prices to penetrate markets.

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 consumer surplus by charging the maximum price each segment is willing to pay.

“Theoretically” is the keyword here because although price skimming can effectively segment the market, it’s almost impossible for the strategy to capture all 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). Necessities like gasoline and electricity are almost always inelastic. However, state-of-the-art products like the iPhone can potentially walk the same path, and businesses, therefore, can charge the highest price. 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.

Advantages of Price Skimming

1. Higher Return on Investment

Charging the highest initial price 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 at the beginning of a product’s life cycle enable you to build a prestigious brand image that actually attracts status-conscious consumers. 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.

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 product pricing 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.

Disadvantages 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 volume. 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, it is crucial to assess customer valuations and analyze the competition (and their market share) before setting your prices. 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. Unless your product includes amazing new features no one can match, it might be a good idea to avoid skimming if you want to maintain a competitive advantage.

3. Price skimming Attracts Competitors

Maybe your product is groundbreaking 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 at 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. Skimming pricing 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 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.

To ensure the customers at the top of your demand curve don’t feel cheated, it’s important to use price skimming consistently 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 the skimming pricing strategy 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 your loyal 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 recoup development costs quickly, continue updating the product, and ensure the survival of your business.

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!

Price Skimming FAQs

What are the most common examples of price skimming?

Some of the most widely known price skimming examples include electronic brands that rely on this strategy during the product launch phase. Their marketing strategies are often directed towards advertising new product functionalities and count on consumers willing to pay a higher price for a sense of exclusivity.

What brands use a price skimming strategy?

Price skimming is a common strategy among tech giants like Apple, Sony Playstation, Samsung, etc. It is also utilized by apparel brands like Nike, Adidas, and others who want to leverage high consumer demand for new products they release.

What is the difference between price skimming vs. penetration pricing?

Both price skimming and penetration pricing are dynamic pricing strategies. However, while price skimming sets high initial prices to target consumers willing to spend more on the latest product, penetration pricing initially relies on low prices to grow their customer base.