The Beginner's Guide to Penetration Pricing

Raise your hand if you miss Blockbuster. Now, raise your hand if you also high-tailed it to the nearest Redbox when they popped up in front of your local McDonald’s.

When Redbox entered the movie rental market in 2002, they led with an aggressively competitive price of $1.00 per day for DVD rentals and no late fees. It was drastically cheaper than Blockbuster’s rental prices of $2.99 or $4.99 per rental, plus late fees of approximately $1.00 per day.

This is an example of penetration pricing and marked the beginning of the end for Blockbuster. In 2009, the once-great video giant tried matching Redbox with its own $1 per day rental program, but it was too late. By then, a DVD subscription service called Netflix was gaining huge swaths of the video rental market.

So, what is penetration pricing exactly? And is it right for your business? Let's find out.

Because this strategy requires companies to slash prices to almost below market value, it’s usually employed by new businesses in a high-growth phase that are prepared to absorb initial losses. These losses are viewed as a necessary sacrifice to gain market share and entice customers away from competitors.

For example, let’s say Dunder Mifflin, an established Scranton paper company, is selling reams of paper for $12.00 per ream. If new startup Michael Scott Paper Company enters the Scranton paper market selling reams for $4.00 per ream — when it costs $3.50 to produce a ream of paper — this would be considered penetration pricing.

Michael Scott Paper Company can’t possibly enjoy sustainable growth by selling their paper at $4.00 per ream. But they can use their initial low prices to disrupt the Scranton paper market, earn a few customers away from Dunder Mifflin, and boost brand recognition.

If you're thinking about leveraging penetration pricing, there are some key points you need to consider. 

What to Have in Mind When Creating a Penetration Pricing Strategy

• Is your product price-elastic? Price-elastic products — ones with demand that fluctuate with price changes — can typically play into effective penetration pricing strategies. If your product is released during a crucial launch period, higher prices could hurt sales and limit your growth. In many cases, a low price can provide a foot in the door for new businesses with price-elastic offerings.
• Is your strategy legal? The line between penetration pricing and shadier practices like loss leader pricing and predatory pricing can often be muddled. Loss leader pricing is a practice where a company sells certain products at a loss with the intention of swaying customers to buy its higher-priced, more profitable offerings.
  
  Predatory pricing is where a company radically undercuts its market in order to drive out any competition, giving that company a monopoly. Once it's in that position, that company raises prices radically to recoup any losses while maintaining its dominant market position.
  
  Loss leader pricing is illegal in around half of all states in the US, and predatory pricing is flat-out illegal everywhere. If you're going to leverage penetration pricing, make sure everything you're doing is legally sound.
• How much faith do you have in your product or service? A penetration pricing strategy rests on the assumption that consumers will be willing to eventually pay more than the lower price you breach the market at. If you want to leverage the tactic, you need to believe that your value proposition will hold up, down the line.

Advantages of a Penetration Pricing Strategy

• New customers - Everyone will like you … for a minute, at least. Consumers love a good deal, so companies offering penetration pricing are often adored and flocked to when they break onto the scene with steeply discounted offers.
• Long-term gains - The economies of scale come into play here. Employing penetration pricing nets a high volume of sales that may offset the lower price tag.
• Market disruption - Offering a product/service at such a low price gives your business a Robin Hood persona. Customers begin to wonder why they’ve been paying so much for the same product or service elsewhere. You win their business and dominate the marketplace, pushing competitors back — or out of the business completely.
• Turnover - This is especially key if you run a retail business. The low price and market disruption mean your product or service flies off the shelves, which benefits retail businesses and distributors.

Disadvantages of a Penetration Pricing Strategy

• Customer dissatisfaction - Eventually, you must raise prices to grow your business. This can cause frustration for customers and bring about retention issues.
• Loss of brand value - When you price and market yourself like a discount brand, you earn a lot of business. But people also start to think of you as a discount brand, causing pushback when you try to price your product or service higher.
• Price war - The gamble with implementing a penetration pricing strategy is that your competitors might retaliate. A pricing war leads to decreased profitability for the market as a whole and benefits no one.
• Inability to raise prices - There’s also the chance that when you try to raise prices on your customers, they just won’t accept it and will take their business elsewhere.

Penetration Pricing Examples

Netflix

Do you grumble a bit every time you receive an email that says your Netflix monthly subscription is going up? Me too. But I also close the email and go back to what I was doing without giving it a second thought. Netflix is a great example of penetration pricing done right.

Netflix opened up shop in 1997, five full years before Redbox became a threat to Blockbuster. It took a little while to build buzz, but they used low prices (a subscription fee of as low as a dollar) to distract consumers from the fact they had to wait up to two days to receive their DVDs in the mail. In 2007, they introduced a streaming service, and the rest is history.

Internet and Cable Providers

Free HBO for six months? 150 extra channels? Complimentary DVR? These are just a few of the ways internet and cable providers practice penetration pricing. They offer impossibly low introductory pricing in order to tempt customers away from competitors. Once that introductory period is over, the prices will gradually — or sometimes very steeply — increase to catch up to the rest of the market.

Fabletics

This athletic clothing brand sends you a three-piece outfit valued at around $100 for only $49.99. This is vastly cheaper than other popular athleisure brands like Lululemon or Athleta which sell a single pair of tights starting at around $100.

The hook? Fabletics is a subscription service. You join their VIP program and receive one "outfit" every month unless you hit the "skip a month" feature before the fifth. Prices this low would likely not be sustainable for the brand without the sheer volume of recurring monthly subscription prices and one-off purchases from their members.

Lay's Stax

In 2003, Frito Lay introduced Lay's Stax, a brand of baked potato chips tailored to compete with Pringles brand chips — with a similar shape, texture, taste, and packaging.

Initially, Frito Lay radically undercut its competition by selling cans of Stax for as low as $0.69. Once the chips got some traction, the company raised their price to reflect what its competition was charging.

Costco

Costco leverages a penetration pricing strategy with its organic grocery products. Generally speaking, the margin on typical groceries isn't particularly high — that's not the case for organic foods, which have more impressive returns. In turn, many grocers sell their organic products with a high mark-up.

Costco, on the other hand, sells organic foods at lower prices — slightly undercutting the market with its own kind of penetration pricing strategy. That said, this is a very specific brand of penetration pricing that not every company can sustainably employ. Since the corporation is as massive as it is, it has more leeway to employ this strategy than a smaller, growing grocer.

Penetration pricing can be an effective pricing strategy for some businesses, but it could just as easily fall flat for others. If you're interested in leveraging the tactic, make sure you understand how it will affect your business plan before implementing it.

Editor's note: This post was originally published in April 2019 and has been updated for comprehensiveness.