Market Skimming

Market Skimming As noted earlier, an innovative product will form the basis of a completely new market, and the producer has all the advantages, and potential dis-advantages, of participating in the introductory phase of the life cycle. Although sales at this stage are likely to be low, and will need to be bolstered by advertising, the demand curve will often be relatively inelastic, giving the producer the opportunity to adopt a 'skimming price' strategy. Market skimming' exploits the novelty appeal of a new product by charging a high initial price, in the knowledge that a lower price in the introductory phase would not lead to significantly greater sales. Recent examples of a successful skimming' policy would include pocket calculators, digital watches and video recorders. Obviously, one objective of market skimming' would be to maximize profitability when a product is first launched. However, it can also act as a form of insurance policy against unexpected increases in manufacturing or distribution costs, particularly where, in the absence of a product history, these costs are of necessity only estimates. It will also help to minimize losses in the unhappy event of a rejection of the product by the market. It has often been pointed out that it is much easier to lower prices than to raise them, particularly if the demand schedule is uncertain; from a psychological point of view it is far better to begin with a high price, which can then be lowered if demand for the product appears to be more sensitive to price than had at first seemed the case. There are two particular circumstances that would dictate the necessary adoption of a skimming price': a) when it is anticipated that the product's life cycle will be relatively short, making it desirable to recover development costs as quickly as possible; b) when the firm has poor liquidity, and high cash flows must be generated as early as possible as a matter of necessity. However, as we saw in the previous section, when alternative pricing strategies for new brands in an existing product market were discussed, high prices will inevitably tempt potential competitors to come into the market, possibly with a lower price that will give them a competitive advantage. Obviously, as in the case of monopoly, for profitable 'skimming' to be sustained, one or more significant barriers to entry must be present to deter these potential competitors. As we saw earlier, examples of such barriers might be patent protection, prohibitively high capital investment, or unusually strong brand loyalty. Nevertheless, where the profit motive is strong enough, even the most significant barriers will be breached eventually, and the innovative producer will inevitably be faced with a critical decision regarding future pricing policy. It can often be more difficult to determine when the time has come to reduce the 'skimming price' than take the initial decision to adopt 'market skimming' when the product is first launched. Strategy and timing will be a function of the strength or weakness of the barriers to entry. As seen in Figure 11.10, when entry barriers are high, prices can be maintained at the 'skimming' level for a considerable time, until the innovative upper share of the market becomes saturated. The price should then be reduced in order to appeal to a more sensitive part of the market, but by dropping the price gradually, as the benefits of the learning curve and increased manufacturing volumes are felt in product costs, margins can be maintained at a high level with relative impunity for some time - until the inevitable partial substitutions appear on the market.