12.3. Market-Based Pricing

Demand based pricing

Market- or demand-based pricing strategies tend to involve pricing products at ‘what the market will bear’. That is, producers will price high if consumer demand is high. For example, high prices are often charged for unique products, like rock festivals and designer clothes, because demand will normally outstrip supply.

Instead of reflecting what the product costs to produce, demand-based pricing asks: ‘At what price will this product sell?’ In adopting this approach, firms will need to carry out careful market research to find out what consumers are willing to pay, and also study the pricing policies of their competitors. Only then will they be able to produce a good or service with the right design and quality to fit the market, and at the right cost to yield a profit.

Market skimming. This strategy, also known as price creaming, is often used when there is little competition in a market. It involves charging a high price for a new product to yield a high initial profit from consumers who are willing to pay extra because the product is new and unique. As competitors enter the market, prices are reduced to encourage the market to expand. Market skimming is a practice often observed in markets for audio and video products. For example, Sony and Phillips were the first manufacturers to release compact disc players in the UK during the mid-1980s. Initially, the players were priced at £500 or more. By 1995, there existed a bewildering variety of CD players, some priced as low as £50.

Penetration pricing. This strategy is used by firms trying to gain a foothold in a new market. It is a high-risk, high-cost strategy that tends to be confined to large firms who supply mass markets. Penetration pricing involves setting product price low to encourage consumers to try the product and to build sales. This will also encourage retailers and wholesalers to stock the product and in doing so reduce their demand for competitors’ goods and services. In addition, the firm may boost sales by lowering price if demand is price-elastic. Cutting price tends to increase total sales revenue if demand is price-elastic. However, in markets where the supply side is very competitive, a price war may develop among rival firms. Any rise in sales from price cuts may be short-lived, as rival firms slash prices in an attempt to retain their market shares. It is often said that only the consumer wins in a price war.

Expansion pricing. This is similar to penetration pricing. Product prices are set low to encourage consumers to buy. As demand increases, the firm is able to raise its level of output and take advantage of economies of scale, which will lower the average cost of producing each unit. Lower average costs can either be passed on to consumers as lower prices, or, if prices are held steady, the lower costs will increase the firm's profit margins.

Price discrimination. This is used when a firm is able to charge different prices to different groups of consumers. For example, British Rail has different prices for peak and off-peak travel. Similarly, British Telecom charges different rates for telephone calls made at peak and off-peak times. Price discrimination is only possible when consumers are unable to undercut higher prices by reselling the product from low-price markets to higher-priced ones. Thus, it is often possible to charge different prices for the same product or service in different regions of the country or world, if the cost of sending the product elsewhere more than offsets any saving in price between areas.