Price Skimming - Let's ride the demand curve down !

Price skimming is an element of price discrimination. It aims at taking advantage from the temporal differences in demand, more particularly when demand is shifting down over time:

Theorically, price skimming allows companies to charge an optimal price to each temporal level of demand, which in turns enables to capture most of consumers' surplus. In this case, "optimal price" would mean a price that optimizes revenue. Indeed, this strategy is mainly used by marketers that have to recover sunk costs before competition enters the market (video games, computers, cell phones, etc).

Most textbooks refer to price skimming as "riding down the demand curve". Generally, it involves setting product prices relatively high compared to direct competition, and then gradually lowering prices. The skimming price is therefore the highest possible price that customers who most desire the product at a certain time will pay.

Let's take a classic example: Apple's iPod. Most iPod consumers are technically sophisticated, and 75% of them are previous Apple customers. This consumer base is very likely to contain people who are nearly not price sensitive to Apple products: The consequence of the iPod's pricing strategy is to progressively skim off the demand (starting with the less elastic portion), sacrificing high sales to profit at the begining.

Justifications for price skimming 

Consumer heterogeneity is the main element of any price skimming – and Revenue Management – strategy. Thus, it is necessary that people have different valuation for the product. An important behavioral element that has also to be accounted for has been brought up by D. Besanko and W.L. Winston: customers’ expectations regarding future prices. Indeed, in their buying process, potential customers weight the benefits of buying today against the benefits of waiting and buying later, which sharpens the time shift in demand.

Stanley Shapiro explains in his book that "A Skimming policy is more attractive if demand is inelastic". A practical definition of an inelastic demand would be that there are no close substitutes, and people are ready to pay a high price for a given product because there is nothing else they can buy that provide them with the same elements (uniqueness, quality, etc).

An important point relates to the use price skimming in absence of any protection against copy. In this case, according to F. Nascimiento and W. R. Vanhonacker, price skimming is optimal for products that can be acquired through either purchase or reproduction. Computer software is a typical example of a product that can be either copied or purchased, and for which price skimming is used to recover development costs and optimize revenues. High prices obviously attract piracy, and Köehler mentions that protection costs may eat up margins.

Inherent risks 

When implementing a price skimming strategy, the greater risk that decision makers face is competition. If illegal copy can be seen as a form of unfair competition, the “regular” competition is generally attracted by the high margins that accompany price skimming, and try to enter the market as quickly as possible. The price policy is effective only in situations where a firm has a substantial lead over competition: Apple's iPhone sets the perfect example. After the first iPhone was launched in January 2007, it almost took two years for the first real competitor to appear, RIM's Blackberry Storm… allowing Apple to enjoy high margins, and great market power in the meantime!

The strategic battle between Sony and Microsoft over the video game consoles market is also a great illustration of how crucial the lead on competition can be. When Sony launches the Playstation 2 in November 2000, Microsoft strikes back in November 2001 with the Xbox… and then kicks in first in 2005, introducing the first 7th generation video game console, the Xbox 360. Sony then fought back, launching the Playstation 3 in November 2006.

This pricing strategy can also raise several other issues. Lowering a product's prices could result in negative publicity, if prices are lowered too fast, without significant product changes; as mentioned previously, price should not be perceived as a sign of quality to apply successfully RM techniques. During the first stages, skimming implies very low inventory turn rates, which may be an issue in the supply chain: retailers may require higher margins to distribute the product.

Another strategy mirrors price skimming: price penetration. It will be the subject of a further article...