Chapter 3. Pricing Strategy
Value | Demand Curves | Skimming | Penetration | Value Maximization
There are three (and only three) pricing strategies:
3a. Skimming
3b. Penetration
3c. Value Maximization
Understanding which to choose requires an unpacking of the concept of Value.
Value
Value is rooted in exchange.
Since the first cavemen traded rocks, humans have been making decisions about exchanges based on what they value.
Today we use money for exchanges. And price is how we quantify value in these exchanges.
From there things get a little tricky.
If the value of a thing was part of its nature we would have an indisputable objective price for everything.
Theorems like Rational Choice Theory (that people always use rational decisionmaking to achieve rational outcomes) and the Efficient Market Hypothesis (all available information is reflected in the price) combined with a Price Performance Analysis (the amount of goods or functional performance I get for the price) would let us calculate a number.
If the value of goods and services was intrinsic and objective, pricing would be easy — there would only be one price which reflected the true value of any product.
But these theories haven’t proven very useful for pricing decisions because value is subjective and extrinsic.
It’s not inherent in the product at all. Instead it lives in the mind of each customer.
That means a product could theoretically have an infinite number of values. This is called the Pricing Uncertainty Principle — which says that all prices are arbitrary and malleable.
Now we’re getting closer to something we can use to make pricing decisions.
In theory the Pricing Uncertainty Principle would tell us that an infinite number of prices might be possible. But even if that’s true, not all possibilities are equally likely.
In practice, we don’t see a smooth spectrum from zero to infinity. Instead we see lumpy clusters where buyers form groups or segments that place a similar value on any product.
Marketing researchers quantify these customers in terms of demand.
Demand is how we see what customers value.
Demand Curves
You’ve probably seen these charts before.
They represent change in demand at various prices.
Given constant demand, increasing the price generally reduces the number of buyers who are willing to pay.
Notice that phrase, willingness-to-pay (WTP). Demand is often referred to as WTP. In fact:
Value = Demand = WTP.
These three terms are practically interchangeable — they all describe the motivation for someone to open their wallet and make a purchase.
The exact correlation between price and demand varies depending on the product.
Changing the price on some products causes a big swing in demand. For other products, price changes have a much smaller effect.
This variance in WTP is called elasticity, or price sensitivity.
And that’s where the choice of strategy comes in.
3a. Skimming
Skimming is charging a lot to a few.
You’re skimming the cream, the topmost layer of WTP from the market.
Lamborghini, for example, isn’t going for volume. In 2020, Lamborghini generated EUR 1.6B in sales on less than 7.5K cars per year.
By comparison, Tesla sold 500K cars, and Toyota sold 9.53M cars.
Skimming is often a strategy used for luxury goods like Lamborghini. It’s effective when people want the status of scarcity and high price.
When customers’ purchase behaviors don’t change much based on price, skimming is at its best.
Consider this. Would your purchase behavior change if I gave you a 10% off coupon for a Lamborghini?
Based on their sales numbers we can estimate that the average price is somewhere around $215K. That coupon would be worth over $20K. But are you ready to rush out and buy one?
Not likely.
In fact, the discount might even tarnish your view of the purchase.
People prefer to pay as little as possible, with the exception of a countervailing social signal, as in the case of a Veblen good.
A Veblen good is a product that people actually value MORE because the price is high and sends a signal about their status.
We want what we can’t have.
Human psychology comes with the FOMO app pre-installed.
And scarcity (i.e., exclusivity or limited supply) drives up demand.
As a result, luxury cars and other Veblens are generally inelastic, i.e., NOT price sensitive.
Real estate and fine art are like this. There’s only one Mona Lisa and only one of any particular address on earth.
Today we can even create unlimited unique NFTs. (Kind of ironic that we can create something both unlimited and unique?)
The bottom line:
This strategy is designed to capture the most revenue from each unit sold, not to sell the most units.
With a skimming strategy you’re pulling the “ticket size” revenue lever.
3b. Penetration
A penetration strategy on the other hand lowers price to reduce friction and achieve maximum volume.
It’s all about capturing as many customers as you can.
In other words, you earn a small contribution margin from each sale while trying to box out competitors and own as much market share as possible.
“Land and expand” approaches start with a penetration strategy, “freemium” and its product-led growth (PLG) successors being the extreme example.
Bottom-up approaches also start with a penetration strategy where you enter down- or mid-market and move upmarket to the enterprise.
A penetration strategy is about pulling the “new sales” revenue lever.
3c. Value Maximization
The Value Maximization strategy is a balancing act between skimming (ticket size) and penetration (new sales).
Both skimming and penetration potentially leave money on the table.
The high skimming price certainly creates a barrier to otherwise willing buyers. And the low penetration price is less than what some buyers are willing to pay.
For companies that want to maximize growth, the value maximization approach strategy lets them pull both “ticket size” and “new sales” levers and try to extract every dollar of revenue the market is willing to pay.
For many, value maximization is the holy grail of pricing strategy.
Additional Reading:
The Personal MBA by Josh Kaufman
