The stage of the product in its life cycle will influence the pricing strategy. Price skimming describes the process of charging a relatively high price for a product. Skimming tends to be used when the product is new to market (in its introduction or growth phase) and has few rivals. Put simply, the company is using price inelasticity to boost revenue; customers are relatively insensitive to price.
Some buyers will want to be seen with this product even if they have paid rather a lot for it. Though this may impact on sales volume, the margins will be higher. The firm is seeking to 'cream' the profit off the top of the market.
So why would a customer pay a high price? There are several reasons - the product may:
- include new technology and is considered the 'latest' gadget.
- be a 'fad' product that everyone wants 'now'.
- be in very limited supply, e.g. original art, high status goods such as a Ferrari.
The company will therefore be able to earn a high return from capital employed. However, skimming tends to be a short-lived strategy as high prices and high profits tend to attract competitors into the market forcing price reductions.
As the product moves through its life cycle, the firm will move away from a price skimming approach. As demand and production increase, the firm will gain economies of scale, lowering unit costs and therefore enabling it to make the same margin despite lower prices.