There is a vast body of research in industrial organization on the influence of industry structure on profitability. Strategy literature suggests that the average profitability of an industry is influenced by five forces which are: (1) rivalry among existing firms, (2) threat of new entrants, (3) threat of substitute products, (4) bargaining power of buyers and (5) bargaining power of suppliers. According to these forces, the intensity of competition determines the potential for creating abnormal profits by the firms in an industry.
In most industries the average level of profitability is primarily influenced by the nature of rivalry among existing firms in the industry. In some industries firms compete aggressively, pushing prices close to the marginal cost. In other industries firms choose to find ways to coordinate their pricing or compete on non-price dimensions such as innovation or brand image.
The potential for earning abnormal profits will attract new entrants to an industry.
The threat of new firms entering an industry potentially places constraint on the pricing of existing firms. Therefore the ease with which new firms can enter an industry is a key determinant of its profitability.
The third dimension of competition in an industry is the threat of substitute products or services. Relevant substitutes are not necessarily those that have the same form as the existing products but those that perform the same function. Threat of substitution can come not from customers switching to another product but from utilizing technologies that allow them to do without, or use less of the existing products.
Two factors determine the power of buyers: price sensitivity and relative bargaining power. Price sensitivity determines the extent to which buyers care to bargain on price and relative bargaining power determines the extent to which they will succeed in forcing the price down.