Penetration Pricing Explained: How Does Penetration Pricing Work?

Penetration pricing is a sales and marketing strategy that offers goods and services at a much lower price point than those offered by existing brands in a market. The goal of the strategy is to eat into another brand's customer base, even if it comes with very low short-term profit margins.

Penetration pricing works by offering an initial price that is notably lower than the going rates in a particular market. In a successful penetration strategy, a business will not just win over customers for one single transaction but will keep them as long-term clients. There are two ways to do this.

1. 1. Build up economies of scale: If an upstart company can win over huge numbers of new customers, it can build brand loyalty by keeping prices low. This may only be possible with massive sales volumes, which keep marginal costs low and allow brands to thrive on the sheer quantity of transactions.
2. 2. Gradually raise prices: Another price penetration strategy is to knock out all of the competition and then gradually raise prices in order to be profitable. Companies can do this when they have access to lots of borrowed capital in their start-up phase. They effectively lose money on early transactions and then, once the competition is priced into oblivion, they slowly ramp up to a relatively high price that can be sustainable over the long term. This can be profitable for the brand over the long term, but it can hurt customers by eliminating competitive markets. Monopolistic business practices like this are also illegal in some countries.

A few types of businesses tend to use penetration pricing strategies.

1. 1. New entrants: Market penetration pricing tends to come from new entrants into an existing market who attempt to pick off customers from the market leaders. The premise is that by offering notably low prices in their initial offering, these companies will peel off customers from brands that charge higher prices.
2. 2. Established brands breaking into new markets: Large, mass-market brands that want to break into a valuable new market may also employ a penetration pricing strategy. For example, some large online retailers have used penetration pricing strategies to roll out new products by their various in-house brands.
3. 3. Price-elastic brands: Brands with products that have price elasticity, meaning the demand for the product is highly dependent on the price, may be more likely to use penetration pricing strategies.

Market penetration is the act of a company wedging itself into an existing market and claiming new customers from established brands. Penetration pricing is one popular way to gain market penetration, but there are other ways as well. These include a price skimming strategy (where you start with high prices and gradually lower them to grab cost-conscious consumers), heavy advertising (where prices reflect the going market rate but you grab customers via ad campaigns), and word-of-mouth campaigns (where you count on early adopters to organically spread the word about your new brand).

Penetration pricing comes with distinct advantages for businesses and customers alike.

1. 1. Rapid customer conversion: Some shoppers consider price point to be the number-one criterion when comparing brands. Manufacturers, service providers, and retailers can quickly win over new clients by offering the lowest price on the market.
2. 2. A path to long-term market dominance: Companies have ridden penetration pricing strategies to long-term market dominance. They do this by operating at massive economies of scale where millions of transactions with low profit margins add up to massive overall profits.
3. 3. Short-term benefit to customers: Competitive markets benefit customers, particularly those who are willing to abandon brand loyalty to get a better price.

Penetration pricing can shake up markets, but this disruption is not always a positive thing.

1. 1. Predatory pricing: Penetration pricing can quickly devolve into predatory pricing where brands with significant amounts of capital can afford to take massive losses. Meanwhile, their small business competitors simply cannot afford negative profit margins. This leads to the big brands knocking out the mom-and-pop stores and creating an environment in which a monopoly can occur. As a result, predatory pricing is illegal in the United States.
2. 2. Unsustainable price wars: Predatory pricing can set off a price war with established brands. These can be great for customers who hop back and forth between competitors in search of lower prices and service upgrades. Over time, however, price wars tend to be unsustainable, leading businesses to burn through all available cash and credit.
3. 3. Diminished brand image: Sometimes it isn't so helpful to be the cheapest place in town. Some customers associate low prices with low quality—particularly when a company doesn't have a legacy reputation to fall back on.

An example of penetration pricing can be found in the streaming video market. Legacy brands typically let their prices increase over time, as they bank on customer loyalty to keep their existing subscriber bases. Upstart streaming services have made initial offerings at much lower price points as a way to pick off potential customers searching for lower costs. The upstarts hope that, if forced to pick one streaming service provider over another, some customers will choose low prices over brand loyalty as they make their entertainment choices.

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