MANAGERIAL ECONOMICS ASSIGNMENT 2

Market Penetration Pricing: The Case of Walmart

Date: 26th August 2011 Submitted By: Name Oswin Diniz Jason Goveas Ankita Jha Rahul Malpani Samik Sarkar Sanjeev Singh Saurabh Suman Roll Number Division 34223 C 34227 C 34230 C 34237 C 34252 C 34258 C 34262 C

In the following paper, we intend to discuss penetration pricing by using Walmart as a case study with an Economic outlook.

We have chosen to take three aspects into account while presenting the paper: 1) The Theory of Market Penetration Pricing 2) How Walmart uses it effectively 3) The downside of the Walmart strategy

Our objective is to look at the impact of the presence of a retail giant like Walmart on the following: 1) 2) 3) 4) 5) Small Retailers Customers Other Chains Suppliers The economy as a whole

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THE THEORY OF MARKET PENETRATION PRICING

Penetration pricing is a strategy used by new-entrants into a market to garner market share or wean over customers from the competition. It is based on the theory of price elasticity of demand1 and assumes that the customers will switch to the new product/brand due to lower prices. It also assumes that once loyalty is developed, the prices can gradually be raised to the prevailing market price and the initial goodwill generated (due to lower prices) will be able to help the company hold onto its customers and also gain referral customers through positive word of mouth.2 At the lower end, penetration pricing emerges from price skimmingi which looks at moving through different layers of the market in a step by step manner by starting at the cream while at the other extreme it runs the risk of moving into the realm of predatory pricingii which is the strategy of pricing so low that the company completely kills of any competitors and is illegal in most countries. Penetration Pricing, however, also comes with its own set of advantages and disadvantages. On the up-side, it can result in rapid proliferation and adoption and quickly corner a high market penetration without giving the competition any reaction time. It also creates cost reduction pressures at every stage in the supply chain and hence often results in higher overall efficiency. The low prices restrict the entry of new competitors and the economies of scale ensure lower per-unit costs which allow further price reductions3. Its biggest strength however is the positive word-of-mouth generated by the low prices which ensures rapid increase in customers4. The detractors of penetration pricing argue that this strategy creates long term price expectations in the customers mind making raising prices at a later stage risky. They claim that only bargain shoppers or switchers are lured in by this kind of pricing and will move away as soon as they find a better deal elsewhere. Also, as it is based upon the concept of lower gains in the short term for greater long term gains, the upper hand may be lost if competitors manage to swiftly match rates as was seen in the case of Tata Docomos per second billing plans5. The company also runs the risk of creating a low price- low quality image in the customers minds. This strategy is based on the assumptions that there is no distinct/identifiable price segment for the market, the demand is price-elastic, there is large enough market for the product and that the competition will soon follow suit and reduce prices so that an eventual price hike is possible and in effect offsets the initial low prices6.
1 2

http://economics.about.com/cs/micfrohelp/a/priceelasticity.htm http://en.wikipedia.org/wiki/Penetration_pricing 3 http://tutor2u.net/business/marketing/pricing_strategy_penetration.asp

4

http://www.more-for-small-business.com/penetration-pricing.html http://www.3gsimplified.com/blog/ http://www.businessdictionary.com/definition/market-penetration-pricing.html

5 6

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WALMART AND PENETRATION PRICING

From Always Low Prices. Always to Save Money. Live Better. The founder of Walmart, Sam Walton, in his autobiography said if you think about it from the point of view of the customer, you want everything: a wide assortment of quality merchandise; the lowest possible prices; guaranteed satisfaction; friendly, knowledgeable service; convenient hours; free parking and a pleasant shopping experience. You love it when a store exceeds your expectations, and you hate it when a store inconveniences you, gives you a hard time, or pretends you're invisible.7 This central theme has ensured that Walmart (founded in 1962) has today grown to a network of 9667 stores and club locations in 28 countries employing 2.1 million associates and serving more than 176 million customers per year. If Walmart was classified as a country, it would be the worlds 21st largest economy with over $315 Billion in sales.8 Walmart has a unique strategy when it comes to penetration pricing. While only 15-25% of Walmarts products are priced below competition, they are placed in strategic high-visibility positions to lure shoppers in and give them the impression that they are actually paying low prices. As a matter of fact, over 80% of Walmarts products are priced higher than the competition.9 However, they do have their own brand of penetration pricing which is carried out for this 15-25% range of products. By promising (and delivering) super-naturally high volumes, Walmart exerts pressure on every step of the supply chain from pre-production to final product output to ensure a cost advantage. As a result, in order to deliver its Everyday low prices, Walmart cuts down the profitability of all its suppliers in order to maximise its own revenues and provide the best value to its customers. 10 This highly effective strategy of Walmart has in turn taken a toll on the other players in the markets in which they have a presence. The entry of Walmart has a devastating effect of other retailers in the area and results in over a 40% fall in their turnover.11 While purportedly, Walmart was built upon the idea of five core customer needs: Low prices, Broad Selection, High Quality, Good Customer Service and Convenience, they have actually grown due to three characteristics of these expectations that have been exploited: 1) The five expectations are not important 2) The importance of specific expectations can be shifted 3) The importance of specific expectations can be decreased

7 8

http://walmartstores.com/aboutus/297.aspx http://exinglobal.typepad.com/going_global/2006/09/the_country_of_.html 9 http://www.zenith-consulting.com/research/walMart/Wal-Mart-Strategy.pdf 10 http://www.fastcompany.com/magazine/77/walmart.html 11 http://www.inc.com/news/articles/2009/04/walmart.html

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By creating an impression in the customers minds that Walmart offers the lowest possible prices, they overshadow the other expectations of customers12. Its a self-created loop that Walmart is stuck in. It used penetration pricing so effectively that price became the most important factor for customer choice. As their suppliers perceive their prices are low, they offer them better prices hence ensuring that lower sourcing costs. Walmart traditionally has kept its operating costs low even at the risk of ill-treating its employees and suppliers. And, now, in order to ensure long-term sustaiability, Walmart needs to continue in the same vein. In recent times, Walmart has realised that there exist negative overtones associated with Walmart and is working towards reducing its negative image. 13 There are various forums which are unhappy with Walmart and its impact on markets and customers and its treatment of its workforce. There are various groups targeting the retail giantiii iv as well as examples of manufacturers who have managed to say no to Walmartv Our verdict is that while Walmart has managed to become the worlds largest retails giant, it owes its success to a few factors other than just penetration pricing: 1) 2) 3) 4)
i

Lack of awareness among customers Lack of counter-action from competitors An outstanding positioning strategy An outstanding usage of the Economies of Scale

Price Skimming: http://www.investopedia.com/terms/p/priceskimming.asp#axzz1W68cNEk1 Predatory Pricing: http://www.oecd.org/dataoecd/7/54/2375661.pdf Women Against Walmart: http://www.the-spearhead.com/2010/04/27/over-one-million-women-set-to-take-down-wal-mart/ iv One woman army: http://www.thedailybeast.com/cheats/2010/05/03/bringing-down-walmart.html v Snapper Lanemowers: http://www.fastcompany.com/magazine/102/open_snapper.html
ii iii

12 13

http://www.street-therapy.com/articles/2-saving-money/14-are-wal-mart-prices-really-lower.html http://www.ibtimes.com/articles/183847/20110720/michelle-obama-walmart-bring-healthy-food-to-food-desert.htm

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