IMPORTANT DISCLAIMER: WE ARE NOT LAWYERS AND THIS IS NOT LEGAL ADVICE! This article reflects the author’s thoughtful opinions on an important subject matter that deserves more attention.
So what is Penetration Pricing?
Penetration Pricing is something that has been used historically, but we’ve seen more and more examples of its use in the age of technology and ecommerce.
Many people do not know what penetration pricing is, or have never even heard of it. Let’s start with the definition:
a pricing strategy in which the price of a product is initially set low to rapidly reach a large portion of the market and initiate word of mouth.
It is easier to understand the true effects of penetration pricing in an economy of scale graphically.
Penetration Pricing Graphically
Graph 1: As you lower your retail price from P1 to P2 the demand curve for your product shifts to the right. Quantity demanded for your product grows from Q1 to Q2.
Graph 2: As Quantity demanded shifts in Graph 1, we can translate that shift in quantity demanded to Average Cost Curve in an Economy of Scale, and clearly see that as Q shifts from Q1 to Q2, average cost per unit moves down from P1 to P2.
Penetration pricing has one goal: to gain as much market share as quickly as possible. Your prices are so low that many consumers forgo considering anything else about your product or service when compared with competitors. Penetration prices sometimes appear to be “too good to be true” and this is precisely why they can be an effective method at catching people’s attention and most importantly getting them to start talking about your product. Everyone is looking for a deal and when they find one that seems “too good to be true”, but actually is true they tend to want to talk about it.
An Important Disclaimer: What Penetration Pricing is NOT
Penetration pricing is not the same as predatory pricing. Predatory pricing is a pricing strategy that intentionally prices products and services unsustainably low with the direct intent of eliminating all competition. Essentially the goal of predatory pricing is to create a monopoly. Once all competition is destroyed and eliminated the company that used predatory pricing now has the ability to “jack prices through the roof.” Who’s going to stop them?
This is illegal in most countries, including the United States of America. In the US, predatory pricing violates antitrust laws. However, it is really difficult to actually prosecute a company for committing predatory pricing practices.
In a paper that was updated in 2015 the Department of Justice claims that, after a lengthy and ongoing study, that economic theory supports that predatory pricing is a problem. However, the problem still remains in distinguishing predatory prices from competitive prices. In the United States, it is not specifically illegal to set your prices below cost. A business or individual is free to charge whatever they please for their products that they sell. Sometimes, setting prices below cost does not harm competition.
The Federal Trade Commission stated that, “A firm's independent decision to reduce prices to a level below its own costs does not necessarily injure competition, and, in fact, may simply reflect particularly vigorous competition.”
What the Supreme Court has to say
The United States Supreme Court has heard many cases regarding predatory pricing practices on the grounds that they violate antitrust laws and regulations and they have set a very high bar for proving that a company has engaged in predatory pricing practices. The largest requirement of which was proving that the prices were intentionally set below cost to effectively eliminate not a single competitor, but all competitors from a market, effectively creating a monopoly.
Essentially what a plaintiff in a lawsuit regarding predatory prices had to prove was that the organization or company that they were suing was engaging in intentional “commercial warfare”. They had to prove that the pricing strategy, that they alleged violated antitrust regulations, was intentionally malicious in nature.
Many times the court has made assumptions regarding predatory pricing scenarios that, during a certain time would have held up, but now seem like generalizations and simply ignorant to the dynamic and complex nature of pricing strategy. In Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. argued in 1993 before the United States Supreme Court and is one of many cases used as a legal precedent when ruling on predatory pricing cases.
The court required that an antitrust plaintiff alleging predatory pricing must show not only changes in market conditions adverse to its interests, as a threshold matter, but must show on the merits that (1) the prices complained of are below an appropriate measure of its rival's costs, and (2) that the competitor had a reasonable prospect or a "dangerous probability" of recouping its investment in the alleged scheme.
Brooke Group v. Brown & Williamson Tobacco Corp.
The case was essentially a battle between name brand cigarettes and generic cigarettes. In the year 1980 cigarette manufacturing in the United States consisted of only six firms. The two parties in the case represented 33% of the entire American cigarette manufacturing industry. In 1980 a subsidiary of Brooke Group Ltd., Liggett, revolutionized the cigarette market by introducing a line of generic cigarettes that were priced effectively 30% less than “branded” cigarettes. Brown & Williamson responded by entering the generic cigarette market, pricing their generic cigarettes below Liggett’s net price. This started a price war in the generic cigarette market which eventually ended with Brown & Williamson ending by selling their generic cigarettes at a net loss. Brown & Williamson was able to do this because of volume rebates that they secured with their wholesalers.
In economics, the law of demand states, “conditional on all else being equal, as the price of a good increases, quantity demanded decreases; conversely, as the price of a good decreases, quantity demanded.” So, effectively what occurred was Brown & Williamson being able to soften their losses from selling below cost by receiving better net wholesale prices as their unit sales increased at the insanely low prices.
Predatory Pricing is Rare
Former Yale law professor and United States Solicitor General Robert Bork believed actual predatory pricing, in its true form, was very rare:
“A firm contemplating predatory price warfare will perceive a series of obstacles that make the prospect of such a campaign exceedingly unattractive. The losses during the war will be proportionally higher for the predator than for the victim . . . the campaign will have to last until the victim’s organization and assets are dissolved; ease of entry will be symmetrical with ease of exit.”
Bork’s argument about predators and victims in cases of predatory pricing practices has one fatal flaw. Bork assumes that the predator will lose more than the victim. If this was the case the victim's best course of action would be to just do nothing and allow the “predator” to lose large amounts of money that they could never recoup via their current “pricing crusade”. However, this is rarely the case.
Predatory pricing is almost always used by firms that have monopolistic characteristics already. Monopolies usually enjoy certain advantages over smaller and newer firms, one of which being that their costs are much lower. If this is the case, a longstanding monopoly may be able to use prices in a predatory manner by selling products at a lesser profit, but not at a loss. A profit that would be higher than their cost but lower than costs of the firms in which they seek to destroy.
Examples of Predatory Pricing
Firm A controls a larger market share of a certain market than any other firm. Firm A sells product A with a cost of $5 for a price of $20.
Firm B wants to enter this market. In many cases, a market that has high profit margins attracts many firms to the market. Firm B, a smaller and more immature firm than Firm A enters the market selling product A with a cost of $10 at a price of $15 in an attempt to undercut Firm A and capture some market share.
Firm A retaliates by pricing product A at $9.99, below Firm B’s cost. Under Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., these types of pricing strategies are legal and do not constitute predatory.
Applying the Law
The questions that arise from an example like this are the same that were asked in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. Ultimately it was ruled that the volume rebates that Brown & Williamson received to soften the blow of their losses by selling below cost did not create competitive injury. It was the consensus of the court that the goal of Brow & Williamson’s pricing strategy was not to eliminate competition, but to send a message to Liggett that the efforts of a price war were futile and that they should raise prices. Liggett wanted prices to return to historic levels, especially for generic cigarettes so that the price differences between generic cigarettes and their branded cigarettes was not as great. This was in their best interest considering that they had a large market share and ultra competitive pricing abilities on more expensive and higher margin branded cigarettes.
Modern Examples of Alleged Predatory Pricing
One example that comes to mind is Wal-Mart. Wal-Mart has been charged numerous times by state courts and even in Europe with pricing products below cost with the intent to drive out competition. This has created a phenomenon in some places where Wal-Mart is the only grocer in town. They come in and out price virtually every other business on everything and capture a vast majority of retail market share in that area.
This is potentially a classic case of predatory pricing per the legal definition. A monopolistic firm, that has low costs to begin with, has the capital to out last a smaller firm in the event of a price war where both firms are taking losses. Wal-Mart has historically been the firm that has been able to afford to “wait it out”. They can reasonably expect to recoup these lost profits once they are sometimes literally, the only game in town.
Another prime example of an alleged case of predatory pricing on a large scale is Uber. Their current business model and the one that has launched the massive publicly traded firm that they are today has a large part to do with price. Uber entered the market as a cheaper and direct competitor to the traditional taxi. The accusations against them of using predatory pricing to harm competition is unique in the sense that Uber did not originally have monopolistic characteristics when they allegedly began practicing predatory pricing strategies.
As seen in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., one of the major requirements for a company to legally be considered a predator who has engaged in predatory pricing is “that the competitor had a reasonable prospect or a "dangerous probability" of recouping its investment in the alleged scheme.”
This would be much easier to prove if Uber already controlled a large part of the market before they dropped their prices to out price the cab companies. However, this was not the case. Uber was very, very small when they allegedly began implementing predatory prices. They did not do it as a retaliatory and defensive measure, as did Brown & Williamson. They also did not use price in the way that Wal-Mart did, as an already firmly established company that was using economies of scale to be able to “wait out the storm” and incur losses while they drowned out smaller competitors in new markets. They instead prices, that some alleged are predatory, to expand their business from the ground up.
From its conception Uber has operated at a loss and originally they operated at a loss with 0% market share. With that being said, their below cost pricing practices were purely a method of quickly introducing their product to market in an attempt to capture market share and even in a sense create a totally new and unique market. It was a huge risk considering that in the early days they were just burning through cash without any reasonable expectation of recouping those losses. This expectation was pertinent to the decision in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. A firm like Wal-Mart can afford to take on losses and never see the money again. In the early days, Uber could not.
Things are different now. In the automobile transportation market Uber alone controls roughly 50% of the market. This is over Lyft and other rideshare firms, taxis, and rental cars. Uber is now in a different position than it was several years ago. They are in a position to turn a profit if they are so pleased to. However, it seems very clear that below cost pricing remains an integral part of Uber’s business model. Uber reported a quarterly loss of $5.2 Billion for Q2 of 2019. To my knowledge there is no other company controlling more than half of the market share in their industry and still losing billions upon billions of dollars in the process.
Uber has been sued in the State of California and has been the subject of a lot of backlash from taxi companies and drivers across the United States, but thus far they have not been legally reprimanded for engaging in any form of illegal pricing practices.
Some Closing Thoughts
Penetration pricing is an awesome pricing strategy for small companies trying to get the word out and even for large firms trying to enter a new sector with their latest product. Penetration Pricing also does many things. It is a great marketing tool, accelerates rapid growth, allows a firm to capture large amounts of market share very quickly, and it creates an additional barrier to entry for other firms that might try and compete. What using the penetration pricing strategy doesn’t mean is that a firm’s bottom line must suffer.
There seems to be a lot of confusion about this key point so let’s conclude with some clarification.
It is a common misconception in the business world that a product of using a penetration pricing strategy is a drop in net income. This is simply false. If implemented properly, penetration pricing will actually do the opposite. A better way to think about what penetration pricing actually does to your sales is to think about profit and revenue not in terms of total profit and total revenue, but instead on a per customer basis.
When using this strategy to launch a new product into the market, you are ultimately using the price of the product as a signal and as a form of communication. You are telling your customers, “Hey! Check out our new product. We know that it’s something that you haven’t used before and you might even be buying from our competitors, but good news! We set our prices so low that you have no reason to not give us a shot. You’ve got nothing to lose!”
Customers tend to be very, very responsive to this signal. At this new (penetrative price), your units sales will climb and rightfully so. Like we talked about earlier, the law of demand states, “conditional on all else being equal, as the price of a good increases, quantity demanded decreases; conversely, as the price of a good decreases, quantity demanded.” With that being said, when using this pricing strategy and looking at your metrics on a per customer basis, your profit per customer will decrease. However, this most certainly doesn’t mean that your total net profits also decrease, because you are now selling more units.
Now here’s the trick. When implementing this pricing strategy, you want to make sure that the percent increase in the number of units sold is greater than the percent decrease in price that imposed on the product. This has a lot to do with elasticity, but we will save that for another time. This is something that will affect your bottom line in the short-run.
In the long-run, the effects of penetration pricing will translate into cost savings in an economy of scale. When you use your penetrative prices to capture large amounts of market share, demand for your product will rise. Even if your margins are thinner, you are selling more units. You now can capitalize on this by using your unit sales increases to save money on variable costs. Economies of scale are a beautiful thing and most industries have the ability to drastically decrease their average cost per unit if only they could scale up.