Jep 14 4 23
Jep 14 4 23
Jep 14 4 23
Case Examples
Companies using information technology to change the way they conduct business
often say that their investment in information technology complements changes in other
aspects of the organization. These complementarities have a number of implications for
understanding the value of computer investment. To be successful, firms typically need to
adopt computers as part of a “system” or “cluster” of mutually reinforcing organizational
changes (Milgrom and Roberts, 1990). Changing incrementally, either by making
computer investments without organizational change, or only partially implementing
some organizational changes, can create significant productivity losses as any benefits of
computerization are more than outweighed by negative interactions with existing
organizational practices (Brynjolfsson, Renshaw and Van Alstyne, 1997). The need for
“all or nothing” changes between complementary systems was part of the logic behind the
organizational reengineering wave of the 1990s and the slogan “Don’t Automate,
Obliterate” (Hammer, 1990). It can also explain why many large scale information
technology projects fail (Kemerer and Sosa, 1991), while successful information
technology adopters earn significant rents.
1 For a more general treatment of the literature on information technology value, see reviews by Brynjolfsson
(1993); Wilson (1995); and Brynjolfsson and Yang (1996). For a discussion of the problems in economic
measurement of computers contributions at the macroeconomic level, see Baily and Gordon (1988), Siegel
(1997), and Gullickson and Harper (1999).
26 Journal of Economic Perspectives
Many of the past century’s most successful and popular organizational practices
reflect the historically high cost of information processing. For example, hierarchical
organizational structures can reduce communications costs because they minimize the
number of communications links required to connect multiple economic actors, as
compared with more decentralized structures (Malone, 1987; Radner, 1993). Similarly,
producing simple, standardized products is an efficient way to utilize inflexible, scale-
intensive manufacturing technology. However, as the cost of automated information
processing has fallen by over 99.9 percent since the 1960s, it is unlikely that the work
practices of the previous era will also be the same ones that best leverage the value of
cheap information and flexible production. In this spirit, Milgrom and Roberts (1990)
construct a model in which firms’ transition from “mass production” to flexible,
computer-enabled, “modern manufacturing” is driven by exogenous changes in the price
of information technology. Similarly, Bresnahan (1999) and Bresnahan, Brynjolfsson and
Hitt (2000) show how changes in information technology costs and capabilities lead to a
cluster of changes in work organization and firm strategy that increase the demand for
skilled labor.
In this section we will discuss case evidence on three aspects of how firms have
transformed themselves by combining information technology with changes in work
practices, strategy, and products and services; they have transformed the firm, supplier
relations, and the customer relationship. These examples provide qualitative insights into
the nature of the changes, making it easier to interpret the more quantitative econometric
evidence that follows.
Table 1
Work Practices at MacroMed as Described in the Corporate Vision Statement
(introduction of computer-based equipment was accompanied by a large set of
complementary changes)
27
Principles of the “old” factory Principles of the “new” factory
ordering, payments, and invoicing are fully automated through electronic data
interchange; products are continuously replenished on a daily basis; and promotional
efforts are replaced by an emphasis on “everyday low pricing.” Manufacturers also
involved themselves more in inventory decisions and moved toward “category
management,” where a lead manufacturer would take responsibility for an entire retail
category (say, laundry products), determining stocking levels for their own and other
manufacturers’ products, as well as complementary items.
These changes, in combination, greatly improved efficiency. Consumers benefited
from lower prices and increased product variety, convenience, and innovation. Without
the direct computer-computer links to scanner data and the electronic transfer of
29
payments and invoices, they could not have attained the levels of speed and accuracy
needed to implement such a system.
Technological innovations related to the commercialization of the Internet have
dramatically decreased the cost of building electronic supply chain links. Computer-
enabled procurement and on-line markets enable a reduction in input costs through a
combination of reduced procurement time and more predictable deliveries, which reduces
the need for buffer inventories and reduces spoilage for perishable products, reduced price
due to increasing price transparency and the ease of price shopping, and reduced direct
costs of purchase order and invoice processing. Where they can be implemented, these
innovations are estimated to lower the costs of purchased inputs by 10 to 40 percent,
depending on the industry (Goldman Sachs, 1999).
Some of these savings clearly represent a redistribution of rents from suppliers to
buyers, with little effect on overall economic output. However, many of the other changes
represent direct improvements in productivity through greater production efficiency and
indirectly by enabling an increase in output quality or variety without excessive cost. To
respond to these opportunities, firms are restructuring their supply arrangements and
placing greater reliance on outside contractors. Even General Motors, once the exemplar
of vertical integration, has reversed course and divested its large internal suppliers. As
one industry analyst recently stated, “What was once the greatest source of strength at
General Motors—its strategy of making parts in-house—has become its greatest
weakness” (Schnapp, 1998). To get some sense of the magnitude of this change, the
spinoff in 1999 of Delphi Automotive Systems, only one of GM’s many internal supply
divisions, created a separate company that by itself has $28 billion in sales.
relationship. For example, Roach (1987) found that while computer investment per white-
collar worker in the service sector rose several hundred percent from 1977 to 1989, output
per worker, as conventionally measured, did not increase discernibly. In several papers,
Morrison and Berndt examined Bureau of Economic Analysis data for manufacturing
industries at the two-digit SIC level and found that the gross marginal product of “high-
tech capital” (including computers) was less than its cost and that in many industries these
supposedly labor-saving investments were associated with an increase in labor demand
(Berndt and Morrison, 1995; Morrison, 1996). Robert Solow (1987) summarized this kind
of pattern in his well-known remark: “[Y]ou can see the computer age everywhere except
in the productivity statistics.”
However, by the early 1990s, analyses at the firm-level were beginning to find
evidence that computers had a substantial effect on firms’ productivity levels. Using data
from over 300 large firms over the period 1988-92, Brynjolfsson and Hitt (1995, 1996)
31
and Lichtenberg (1995) estimated production functions that use the firm’s output (or
value-added) as the dependent variable and include ordinary capital, information
technology capital, ordinary labor, information technology labor, and a variety of dummy
variables for time, industry, and firm. 2 The pattern of these relationships is summarized in
Figure 1, which compares firm-level information technology investment with multifactor
productivity (excluding computers) for the firms in the Brynjolfsson and Hitt (1995)
dataset. There is a clear positive relationship, but also a great deal of individual variation
in firms’ success with information technology.
Estimates of the average annual contribution of computer capital to total output
generally exceed $.60 per dollar of capital stock often by a substantial margin, depending
on the analysis and specification (Brynjolfsson and Hitt, 1995, 1996; Lichtenberg, 1995;
Dewan and Min, 1997). These estimates are statistically different from zero, and in most
cases significantly exceed the expected rate of return of about $.42 (the Jorgensonian
rental price of computers—see Brynjolfsson and Hitt, 2000). This suggests either
abnormally high returns to investors or the existence of unmeasured costs or barriers to
investment. Similarly, most estimates of the contribution of information systems labor to
output exceed $1 for every $1 of labor costs.
Several researchers have also examined the returns to information technology using
data on the use of various technologies rather than the size of the investment. Greenan
and Mairesse (1996) matched data on French firms and workers to measure the
relationship between a firm’s productivity and the fraction of its employees who report
using a personal computer at work. Their estimates of computers’ contribution to output
are consistent with earlier estimates of the computer’s output elasticity.
Other micro-level studies have focused on the use of computerized manufacFigure 1
Productivity Versus Information Technology Stock (Capital plus Capitalized Labor)
for Large Firms (1988–1992), Adjusted for Industry
2 These studies assumed a standard form (Cobb-Douglas) for the production function, and measured the
variables in logarithms. Later work using different functional forms, such as the transcendental logarithmic
(translog) production function, has little effect on the measurement of output elasticities.
32 Journal of Economic Perspectives
turing technologies. Kelley (1994) found that the most productive metal-working plants
use computer-controlled machinery. Black and Lynch (1996) found that plants where a
larger percentage of employees use computers are more productive in a sample containing
multiple industries. Computerization has also been found to increase productivity in
government activities both at the process level, such as package sorting at the post office
or toll collection (Muhkopadhyay, Rajiv and Srinivasan, 1997) and at higher levels of
aggregation (Lehr and Lichtenberg, 1998).
Taken collectively, these studies suggest that information technology is associated
with substantial increases in output and productivity. Questions remain about the
mechanisms and direction of causality in these studies. Perhaps instead of information
technology causing greater output, “good firms” or average firms with unexpectedly high
sales disproportionately spend their windfall on computers. For example, while Doms,
Dunne and Troske (1997) found that plants using more advanced manufacturing
technologies had higher productivity and wages, they also found that this was commonly
the case even before the technologies were introduced.
Efforts to disentangle causality have been limited by the lack of good instrumental
variables for factor investment at the firm-level. However, attempts to correct for this bias
using available instrumental variables typically increase the estimated coefficients on
information technology even further (for example, Brynjolfsson and Hitt, 1996; 2000).
Thus, it appears that reverse causality is not driving the results: firms with an unexpected
increase in free cash flow invest in other factors, such as labor, before they change their
spending on information technolErik Brynjolfsson and Lorin M. Hitt
ogy. Nonetheless, as the case studies underscore, there appears to be a fair amount of
causality in both directions—certain organizational characteristics make information
technology adoption more likely and vice versa.
The firm-level productivity studies can shed some light on the relationship between
information technology and organizational restructuring. For example, productivity
studies consistently find that the output elasticities of computers exceed their (measured)
input shares. One explanation for this finding is that the output elasticities for information
technology are about right, but the productivity studies are underestimating the input
quantities because they neglect the role of unmeasured complementary investments.
Dividing the output of the whole set of complements by only the factor share of
information technology will imply disproportionately high rates of return for information
technology.3
A variety of other evidence suggests that hidden assets play an important role in the
relationship between information technology and productivity. Brynjolfsson and Hitt
(1995) estimated a firm fixed effects productivity model. This method can be interpreted
as dividing firm-level information technology benefits into two parts; one part is due to
variation in firms’ information technology investments over time, the other to fixed firm
characteristics. Brynjolfsson and Hitt found that in the firm effects model, the coefficient
on information technology was about 50 percent lower, compared to the results of an
ordinary least squares regression, while the coefficients on the other factors, capital and
labor, changed only slightly. This change suggests that unmeasured and slowly changing
3 Hitt (1996) and Brynjolfsson and Hitt (2000) present a formal analysis of this issue.
33
organizational practices (the “fixed effect”) significantly affect the returns to information
technology investment.
Another indirect implication from the productivity studies comes from evidence that
effects of information technology are substantially larger when measured over longer time
periods. Brynjolfsson and Hitt (2000) examined the effects of information technology on
productivity growth rather than productivity levels, which had been the emphasis in most
previous work, using data that included more than 600 firms over the period 1987 to
1994. When one-year differences in information technology are compared to one-year
differences in firm productivity, the measured benefits of computers are approximately
equal to their measured costs. However, the measured benefits rise by a factor of two to
eight as longer time periods are considered, depending on the econometric specification
used. One interpretation of these results is that short-term returns represent the direct
effects of information technology investment, while the longer-term returns represent the
effects of information technology when combined with related investments in
organizational change. Further analysis, based on earlier results by Schankerman (1981)
in the R&D context, suggested that these omitted factors were not simply information
technology investments and complements that were erroneously misclassified as capital
or labor. Instead, to be consistent with the econometric results, the omitted factors had to
have been accumulated in ways that would not appear on the current balance sheet. Firm-
specific human capital and “organizational capital” are two examples of omitted inputs
that would fit this description.4
A final perspective on the value of these organizational complements to information
technology can be found using financial market data, drawing on the literature on Tobin’s
q. This approach measures the rate of return of an asset indirectly, based on comparing
the stock market value of the firm to the replacement value of the various capital assets it
owns. Typically, Tobin’s q has been employed to measure the relative value of observable
assets such as R&D or physical plant. However, as suggested by Hall (1999a, b), Tobin’s
q can also be viewed as providing a measure of the total quantity of capital, including the
value of “technology, organization, business practices, and other produced elements of
successful modern corporation.” Using an approach along these lines, Brynjolfsson and
Yang (1997) found that while one dollar of ordinary capital is valued at approximately
one dollar by the financial markets, one dollar of information technology capital appears
to be correlated with on the order of $10 of additional stock market value for Fortune
1000 firms using data spanning 1987 to 1994. Since these results, for the most part, apply
to large, established firms rather than new high-tech start-ups, and since they predate most
of the massive increase in market valuations for technology stocks in the late 1990s, these
results are not likely to be sensitive to the possibility of a recent “high-tech stock bubble.”
A more likely explanation for these results is that information technology capital is
disproportionately associated with intangible assets like the costs of developing new
software, populating a database, implementing a new business process, acquiring a more
highly skilled staff, or undergoing a major organizational transformation, all of which go
uncounted on a firm’s balance sheet. In this interpretation, for every dollar of information
technology capital, the typical firm has also accumulated about $9 in additional intangible
4 Part of the difference in coefficients between short and long difference specifications could also be explained
by measurement error (which tends to average out over longer time periods). Such errorsin-variables can bias
down coefficients based on short differences, but the size of the change is too large to be attributed solely to this
effect (Brynjolfsson and Hitt, 2000).
34 Journal of Economic Perspectives
assets. A related explanation is that firms must occur substantial “adjustment costs”
before information technology is effective. These adjustment costs drive a wedge between
the value of a computer resting on the loading dock and one that is fully integrated into
the organization.
The evidence from both the productivity and Tobin’s q analyses provides some
insights into the properties of information technology-related intangible assets, even if we
cannot measure these assets directly. Such assets are large, potentially several multiples
of the measured information technology investment. They are unmeasured in the sense
that they do not appear as a capital asset or as other components of firm input, although
they do appear to be unique characteristics of particular firms as opposed to industry
effects. Finally, they have more effect in the long term than the short term, suggesting that
multiple years of adaptation and investment is required before their influence is
maximized.
Beyond Computation: Information Technology and Organizational Transformation
Figure 2
Market Value as a Function of Information Technology and Work Organization
Source: This graph was produced by nonparametric local regression models using data from Brynjolfsson, Hitt
and Yang (2000).
relationship is particularly striking for firms that are simultaneously extensive users of
information technology and highly decentralized (Brynjolfsson, Hitt and Yang, 2000).
The weight of the firm-level evidence shows that a combination of investment in
technology and changes in organizations and work practices facilitated by these
technologies contributes to firms’ productivity growth and market value. However, much
work remains to be done in categorizing and measuring the relevant changes in
organizations and work practices, and relating them to information technology and
productivity.
37
The Divergence of Firm-level and Aggregate Studies on Information
Technology and Productivity
While the evidence indicates that information technology has created substantial
value for firms that have invested in it, it has sometimes been a challenge to link these
benefits to macroeconomic performance. A major reason for the gap in interpretation is
that traditional growth accounting techniques focus on the (relatively) observable aspects
of output, like price and quantity, while neglecting the intangible benefits of improved
quality, new products, customer service and speed. Similarly, traditional techniques focus
on the relatively observable aspects of investment, such as the price and quantity of
computer hardware in the economy, and neglect the much larger intangible investments in
developing complementary new products, services, markets, business processes, and
worker skills. Paradoxically, while computers have vastly improved the ability to collect
and analyze data on almost any aspect of the economy, the current computer-enabled
economy has become increasingly difficult to measure using conventional methods.
Nonetheless, standard growth accounting techniques provide a useful starting point for
any assessment or for the contribution of information technology to economic growth.
Several studies of the contribution of information technology concluded that
technical progress in computers contributed roughly 0.3 percentage points per year to real
output growth when data from the 1970s and 1980s were used (Jorgenson and Stiroh,
1995; Oliner and Sichel, 1994; Brynjolfsson, 1996).
Much of the estimated growth contribution comes directly from the large quality-
adjusted price declines in the computer producing industries. The nominal value of
purchases of information technology hardware in the United States in 1997 was about 1.4
percent of GDP. Since the quality-adjusted prices of computers decline by about 25
percent per year, simply spending the same nominal share of GDP as in previous years
represents an annual productivity increase for the real GDP of 0.3 percentage points (that
is, 1.4 3 .25 5 .35). A related approach is to look at the effect of information technology
on the GDP deflator. Reductions in inflation, for a given amount of growth in output,
imply proportionately higher real growth and, when divided by a measure of inputs,
higher productivity growth as well. Gordon (1998, p. 4) calculates that “computer
hardware is currently contributing to a reduction of U.S. inflation at an annual rate of
almost 0.5 percent per year, and this number would climb toward one percent per year if a
broader definition of information technology, including telecommunications equipment,
were used.”
More recent growth accounting analyses by the same authors have linked the recent
surge in measured productivity in the U.S. to increased investments in information
technology. Using similar methods as in their earlier studies, Oliner and Sichel (this issue)
and Jorgenson and Stiroh (1999) find that the annual contribution of computers to output
growth in the second half of the 1990s is closer to 1.0 or 1.1 percentage points per year.
Gordon (this issue) makes a similar estimate. This is a large contribution for any single
technology, although researchers have raised concerns that computers are primarily an
intermediate input and that the productivity gains are disproportionately visible in
computer-producing industries as opposed to computer-using industries. For instance,
Gordon notes that after he makes adjustments for the business cycle, capital deepening
and other effects, there has been virtually no change in the rate of productivity growth
38 Journal of Economic Perspectives
outside of the durable goods sector. Jorgenson and Stiroh ascribe a larger contribution to
computer-using industries, but still not as great as in the computer-producing industries.
Beyond Computation: Information Technology and Organizational Transformation
Table 2
Annual (Measured) Productivity Growth for Selected Industries (based on dividing
BEA gross output by industry figures by BLS hours worked by industry for comparable
sectors)
42 Journal of Economic Perspectives
Industry 1948–1967 1967–1977 1977–1996
began selling in volume. This leads the price index to miss the rapid decline in price that
many new goods experience early in their product cycle. In a related example, in 1990,
sales of the printed multi-volume Encyclopedia Britannica were $650 million and the
production cost for each set was over $250, plus up to $500 for the salesperson’s
commission (Evans and Wurster, 2000). Producing a CD-ROM with the same
information now costs less than $1, and presenting it via a website like
www.britannica.com, costs but a fraction of that. Sales of the printed version of all
encyclopedias, including Britannica, collapsed by over 80 percent in the 1990s, as the
content was bundled for “free” with office software or delivered on the web. The GDP
statistics captured this collapse in sales, but not the value of the content that is now free or
nearly free. As a result, the inflation statistics overstate the true rise in the cost of living,
and when the nominal GDP figures are adjusted using that price index, the real rate of
output growth is understated (Boskin et al., 1997). The problem extends beyond new
high-tech products, like personal digital assistants and web browsers. Computers enable
more new goods to be developed, produced, and managed in all industries. For instance,
the number of new products introduced in supermarkets has grown from 1281 in 1964, to
1831 in 1975, and then to 16,790 in 1992 (Nakamura, 1997); the data management
requirements to handle so many products would have overwhelmed the computerless
supermarket of earlier decades. Consumers have voted with their pocketbooks for the
stores with greater product variety.
This collection of results suggests that information technology may be associated
with increases in the intangible component of output, including variety, customer
convenience, and service. Because it appears that the amount of unmeasured output value
is increasing with computerization, this measurement problem not only creates an
underestimate of output level, but also errors in measurement of output and productivity
growth when compared with earlier time periods which had a smaller bias due to
intangible outputs.
Just as the Bureau of Economic Analysis successfully reclassified many software
expenses as investments and is making quality adjustments, perhaps we will also find
ways to measure the investment component of spending on intangible organizational
capital and to make appropriate adjustments for the value of all gains attributable to
improved quality, variety, convenience and service. Unfortunately, addressing these
problems can be difficult even for single firms and products, and the complexity and
number of judgments required to address them at the macroeconomic level is extremely
high. Moreover, because of the increasing service component of all industries (even basic
manufacturing), which entails product and service innovation and intangible investments,
these problems cannot be easily solved by focusing on a limited number of “hard to
measure” industries—they are pervasive throughout the economy.
43
Meanwhile, however, firm-level studies can overcome some of the difficulties in
assessing the productivity gains from information technology. For example, it is
considerably easier at the firm level to make reasonable estimates of the investments in
intangible organizational capital and to observe changes in organizations, while it is
harder to formulate useful rules for measuring such investment at the macroeconomic
level.
Firm-level studies may be less subject to aggregation error when firms make
different levels of investments in computers and thus could have different capabilities for
producing higher value products (Brynjolfsson and Hitt, 1996, 2000). Suppose a firm
invests in information technology to improve product quality and consumers recognize
and value these benefits. If other firms do not make similar investments, any difference in
quality will lead to differences in the equilibrium product prices that each firm can
charge. When an analysis is conducted across firms, variation in quality will contribute to
differences in output and productivity and thus, will be measured as increases in the
output elasticity of computers. However, when firms with high quality products and firms
with low quality products are combined together in industry data (and subjected to the
same quality-adjusted deflator for the industry), both the information technology
investment and the difference in revenue will average out, and a lower correlation
between information technology and (measured) output will be detected. Interestingly,
Siegel (1997) found that the measured effect of computers on productivity was
substantially increased when he used a structural equation framework to directly model
the errors in production input measurement in industry-level data.
However, firm-level data can be an unreliable way to capture the social gains from
improved product quality. For example, not all price differences reflect differences in
product or service quality. When price differences are due to differences in market power
that are not related to consumer preferences, then firm-level data will lead to inaccurate
estimates of the productivity effects of information technology. Similarly, increases in
quality or variety (like new product introductions in supermarkets) can be a by-product of
anticompetitive product differentiation strategies, which may or may not increase total
welfare. Moreover, firm-level data will not fully capture the value of quality
improvements or other intangible benefits if these benefits are ubiquitous across an
industry, because then there will not be any interfirm variation in quality and prices.
Instead, competition will pass the gains on to consumers. In this case, firm-level data will
also understate the contribution of information technology investment to social welfare.
Erik Brynjolfsson and Lorin M. Hitt
Conclusion
Concerns about an information technology “productivity paradox” were raised in the
late 1980s. Over a decade of research since then has substantially improved our
understanding of the relationship between information technology and economic
performance. The firm-level studies in particular suggest that, rather than being
paradoxically unproductive, computers have had an impact on economic growth that is
disproportionately large compared to their share of capital stock or investment, and this
impact is likely to grow further in coming years.
44 Journal of Economic Perspectives
In particular, both case studies and econometric work point to organizational
complements such as new business processes, new skills and new organizational and
industry structures as a major driver of the contribution of information technology. These
complementary investments, and the resulting assets, may be as much as an order of
magnitude larger than the investments in the computer technology itself. However, they
go largely uncounted in our national accounts, suggesting that computers have made a
much larger real contribution to the economy than previously believed.
The use of firm-level data has cast a brighter light on the black box of production in
the increasingly information technology-based economy. The outcome has been a better
understanding of the key inputs, including complementary organizational assets, as well
as the key outputs including the growing roles of new products, new services, quality,
variety, timeliness and convenience. Measuring the intangible components of
complementary systems will never be easy. But if researchers and business managers
recognize the importance of the intangible costs and benefits of computers and undertake
to evaluate them, a more precise assessment of these assets needn’t be beyond
computation.
y Portions of this manuscript are to appear in MIS Review and in an edited volume, The
Puzzling Relations Between Computer and the Economy, Nathalie Greenan, Yannick
Lhorty and Jacques Mairesse, eds., MIT Press, 2001.
The authors thank David Autor, Brad De Long, Robert Gordon, Shane Greenstein,
Dale Jorgenson, Alan Krueger, Dan Sichel, Robert Solow, Kevin Stiroh and Timothy
Taylor for valuable comments on (portions of) earlier drafts. This work is funded in part
by NSF Grant
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