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.

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 in 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 skimmersŐ 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.

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.