Why some do IT better

Nicholas Bloom, Raffaella Sadun, John Van Reenen, 17 July 2007

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What has been the impact of information technology (IT) on productivity? This question has troubled policy-makers, economists and business leaders for decades. Somewhat ironically, research on the impact of IT was held back by the state of IT. Only in recent years has the power of computers enabled researchers to use large-scale datasets on firms in a way that allows researchers to develop answers. In our recent Policy Insight, we report and synthesise some of the main messages emerging from this new line of research.

Perhaps the most intriguing finding comes from information on IT usage by global businesses. Multinational enterprises in general and American multinationals in particular appear to have higher productivity, and this seems to be linked to a distinct pattern in their use of IT. This fact may help unravel some of the productivity puzzles of the last two decades, chief among them the US productivity pick-up that was not echoed in Europe (apart from Ireland and Finland). The bottom line of the analysis confirms what business leaders have long known – the returns to IT are extremely variable; what matters is the management and organisation of the firm into which the IT is placed.

Productivity: the long view

Labour productivity (output per hour worked) is the key to an economy’s material wellbeing and its growth is the key to per capita income growth. Over the last 60 years, labour productivity has waxed and waned, but three periods distinguish themselves. Starting with the end of WWII, productivity growth was strong throughout in the developed world, but stronger in Europe than in the US. The second phase started when this ‘golden age of growth’ shuddered to a halt with the 1973 oil shock. Since this second phase coincided with the widespread introduction of computers into the work place, a paradox arose, the so-called ‘Solow paradox.’ As Robert Solow remarked at the time, computers could be seen everywhere except in the productivity statistics.1 The second phase was not all bad news for Europe; despite the slowdown, Europe’s productivity continued to catch up with US productivity levels right up to the mid-1990s. Some European countries even overtook the United States in the output-per-hour race.

The third phase began in the mid-1990s with the so-called ‘new economy’ revival of rapid growth in the US driven by productivity growth rates that rivalled those of the 1945-1973 golden era. Even the ‘tech wreck’ of 2000, when the high-tech stock market bubble burst, failed to dent the rapid rise of labour productivity in the US. Europeans, however, mostly remained in the second phase. The long catching-up process came to a halt.

When searching for explanations for the US-versus-European growth performace, a natural candidate is IT investment. In the US, the pick up in US productivity growth was accompanied by a dramatic acceleration in US investment in IT that was unmatched in Europe. Moreover, IT seems to matter for understanding the US ‘productivity miracle’. If one splits the US economy into three sectors – sectors that produce IT (semi-conductors and computing), sectors that use IT (retail, wholesale and finance), and all other sectors – it turns out that the IT-producing and IT-using sectors essentially account for nearly all of the acceleration in US productivity growth.2

Looking at Europe, we also see a big increase in productivity growth in the IT-producing sectors of about 1.6% a year. The main difference between the United States and Europe is in the IT-using sectors. In Europe, there was no productivity acceleration in the late 1990s as there was in the United States. Productivity growth remained static at about 2% a year. Since IT is available throughout the world at broadly similar prices, this raises a puzzle: why were European firms not able to reap the same benefits from IT as their US counterparts? To answer this, we have to delve beneath the macroeconomic numbers into the firm-level evidence.

The microeconomic picture

Since IT is one form of capital, identifying the impact of IT on output requires the researcher to take into account other forms of non-IT capital, such as buildings, vehicles and non-IT equipment. Labour and material inputs also have to be controlled for, as well as other factors such as plant age, location and the state of the business cycle. The best studies use data where the same firms are followed over time so the researcher can see if a burst of IT capital is followed by a burst of productivity after controlling for other factors.
Several interesting findings have emerged from this research programme (see Draca, Sadun and Van Reenen, 2007, for a more extensive survey).

  • On average, IT is associated with much higher firm-level productivity.

This stands in contrast with some of the earlier industry- and macro-level studies that struggled to find any effect of IT on productivity. The reason why the industry-level and economy-level studies found little impact may have been because the industry averages disguise large differences between firms within industries.

  • The magnitude of the association between IT and company productivity is substantial.

If IT were simply a normal form of capital earning the usual market return, we would expect that a doubling of the IT capital stock would increase output by approximately the share of IT in total revenues -- about 1-2% in most studies. The rewards to IT investment, however, appear to be much greater than this. The meta-analysis of twenty studies reported in Stiroh (2002b) finds an average IT-output elasticity of 5%, suggesting that a 1% increase of the IT stock increases productivity by 5%. This would seem to suggest that there are some special features of IT compared with other forms of capital.

  • There is a huge variation around the average impact of IT on firm productivity between different studies.

Stiroh (2004) reports estimates ranging from an upper end of over 25% to negative 5%. Some of these differences are due to methodological differences. But it is more likely that a large amount of this variation is due to genuine differences in the impact of IT across firms and this is reflected in the different results from different datasets.
To understand this heterogeneity, we must move beyond looking only at technology and investigate other features of the firm.

The role of organisational change

An important reason why the returns to IT differ across firms is that different firms have very different environments into which IT is placed. Often IT spending is only the tip of the iceberg. A whole host of other investments are made to enhance the use of IT, for example consultancy expenses and business re-engineering.

Skills are also important. There is a great deal of evidence that educated workers tend to be much better at coping with the uncertainties of new IT systems than less skilled workers. Other organisational factors such as decentralisation of decision-making and the steepness of the managerial hierarchy have been found to be important. Old-style ‘Taylorist’ organisations with rigid centralised hierarchies have, on average, produced lower returns to IT than more flexible firms.

Whether firms make these investments in complementary organisational capital seems to be very important. Bresnahan et al. (2002) examined the impact of IT on productivity in over 300 large US companies. A 1% increase in the IT stock was associated with an increase in productivity of 3.6%, but this increased to 5.8% if a firm became more decentralised (in their study, a one unit increase on a decentralisation index based around teamwork and autonomy of workers).

Much more to be learned

Although this literature is in its early stages, the research suggests that other organisational and managerial factors - which cannot be studied in isolation - interact with the use and the effects of IT on productivity, The bulk of the evidence from firm-level, microeconomic studies is that IT does have an economically and statistically significant impact on productivity but this varies dramatically between firms. Having the right organisation is important in getting the most out of IT investment. Organisational differences lie behind US versus Europe productivity performance – US firms are better placed to take advantage of IT. This could be due to their ability to reorganize more quickly because of lighter labour regulation.

Our basic theory predicts that European firms will adopt more US-style business processes over time and that this will allow them to restart on closing the productivity gap with the US. Indeed, over the last year European growth has been stronger than American growth which may indicate that after a decade the European Tortoise may be catching-up with the US Hare. The risk for Europe, however, is that the world economy is actually a more uncertain and volatile place than it was in the post-war period. If this is the case, then the nimbler US economy will maintain its position at the productivity frontier for a long time to come.

 


1  Robert S. Solow, "We'd Better Watch Out," New York Times Book Review, 1987

2 Kevin Stiroh (2002), ‘Information Technology and the US Productivity Revival: What Do the Industry Data Say?’, American Economic Review 92(5), 1559-76.

 

URL:  http://www.cepr.org/pubs/PolicyInsights/CEPR_Policy_Insight_007.asp

Topics:  Productivity and Innovation

Tags:  IT, productivity, organizational change

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