Wired for Innovation: How Information Technology Is Reshaping the Economy

Wired for Innovation

Wired for Innovation

How Information Technology Is Reshaping the Economy

Erik Brynjolfsson and Adam Saunders

The MIT Press

Cambridge, Massachusetts

London, England

© 2010 Massachusetts Institute of Technology

All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher.

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Set in Palatino. Printed and bound in the United States of America.

Library of Congress Cataloging-in-Publication Data

Brynjolfsson, Erik.

Wired for innovation : how information technology is reshaping the economy / Erik Brynjolfsson and Adam Saunders.

    p.  cm.

Includes bibliographical references and index.

ISBN 978-0-262-01366-6 (hardcover : alk. paper)

1. Technological innovations—Economic aspects. I. Saunders, Adam.

II. Title.

HC79.T4.B79 2009

303.48'33—dc22

2009013165

10 9 8 7 6 5 4 3 2 1

d_r0

Contents

Acknowledgments vii

Introduction ix

1 Technology, Innovation, and Productivity in the Information Age 1

2 Measuring the Information Economy 15

3 IT’s Contributions to Productivity and Economic Growth 41

4 Business Practices That Enhance Productivity 61

5 Organizational Capital 77

6 Incentives for Innovation in the Information Economy 91

7 Consumer Surplus 109

8 Frontier Research Opportunities 117

Notes 129

Bibliography 135

Index 149

Acknowledgments

The idea for this book originated in a request by Michael LoBue of the Institute for Innovation and Information Productivity for an accessible overview of research and open issues in the areas of IT innovation and productivity. With guidance and inspiration from Karen Sobel Lojeski at the IIIP, and through the IIIP’s research sponsorship of the MIT Center for Digital Business, we were able to devote more than a year to studying the main research results in these areas and to producing a report that eventually became this book.

We are also grateful to the National Science Foundation, which provided partial support for Erik Brynjolfsson (grant IIS-0085725), and to the other research sponsors of the MIT Center for Digital Business, including BT, Cisco Systems, CSK, France Telecom, General Motors, Google, Hewlett-Packard, Hitachi, Liberty Mutual, McKinsey, Oracle, SAP, Suruga Bank, and the University of Lecce. We thank Paul Bethge and Jane Macdonald at the MIT Press for their editing and for expert assistance with the publication process. Heekyung Kim, Andrea Meyer, Dana Meyer, Craig Samuel, and Irina Starikova commented on drafts of portions of the manuscript.

The ideas, examples, and concepts discussed in the book were inspired over a period of years by numerous stimulating conversations with our colleagues at MIT and in the broader academic and business communities. In particular, we’d like to thank Masahiro Aozono, Chris Beveridge, John Chambers, Robert Gordon, Lorin Hitt, Paul Hofmann, Dale Jorgenson, Henning Kagermann, David Verrill, and Taku Tamura for sharing insights and suggestions. Most of all, we would like to thank Martha Pavlakis and Galit Sarfaty for their steadfast support and encouragement.

Introduction

The fundamentals of the world economy point to continued innovation in technology through the booms and busts of the financial markets and of business investment. Gordon Moore predicted in 1965 that the number of transistors that could be placed on a microchip would double every year. (Later he revised his prediction to every two years.) That prediction, which became known as Moore’s Law, has held for four decades. Furthermore, businesses have not even exploited the full potential of existing technologies. We contend that even if all technological progress were to stop tomorrow, businesses could create decades’ worth of IT-enabled organizational innovation using only today’s technologies. Although some say that technology has matured and become commoditized in business, we see the technological revolution as just beginning. Our reading of the evidence suggests that the strategic value of technology to businesses is still increasing. For example, since the mid 1990s there has been a dramatic widening in the disparity in profits between the leading and lagging firms in industries that use technology intensively (as opposed to producing technology). Non-IT-intensive industries have not seen a comparable widening of the performance gap—an indication that deployment of technology can be an important differentiator of firms’ strategies and their degrees of success.

Despite decades of high growth in investment, official measures of information technology suggest that it still accounts for a relatively small share of the US economy. Though roughly half of all investment in equipment by US businesses is in information-processing equipment and software (as has been the case since the late 1990s), less than 2 percent of the economy is dedicated to producing hardware and software. When the computer systems design and related services industry is added, as well as information industries such as publishing, motion picture and sound recording, broadcasting and telecommunications, and information and data processing services, the total value added amounts to less than 7 percent of the economy. However, when it comes to innovation the story is quite different: every year in the period 1995-2007, between 50 percent and 75 percent of venture capital went into the funding of companies in the IT-production and information industries. We also see much greater turbulence and volatility in the information industries, reflecting the gale of creative destruction that inevitably accompanies disruptive innovation. Firms in those industries have a much higher ratio of intangible assets to tangible ones. Because valuing intangibles is difficult, wealth for firms in these industries is often created or destroyed much more rapidly than for firms that are in the business of creating physical goods.

The literature on productivity points to a clear conclusion: information technology has been responsible, directly or indirectly, for most of the resurgence of productivity in the United States since 1995. Before 1995, decades of investment in information technology seemed to yield virtually no measurable overall productivity growth (an effect commonly referred to as the productivity paradox). After 1995, however, productivity increased from its long-term growth rate of 1.4 percent per year to an average of 2.6 percent per year until 2000. But information technology wasn’t the sole cause of the increased growth. A significant body of research finds that the reason technology played a larger role in the acceleration of productivity in the United States than in other industrialized countries is that American firms adopted productivity-enhancing business practices along with their IT investments.

In the period 2001-2003, productivity growth accelerated to 3.6 percent per year, making that the best three-year period of productivity growth since 1963-1965. Whereas economists generally agree on the causes of the 1995-2000 productivity surge, there is less consensus in the literature about the 2001-2003 surge. We attribute it to the delayed effects of the huge investments in business processes that accompanied the large technology investments of the late 1990s. The literature suggests that it can take several years for the full effects of technology investments on productivity to be realized because of the resultant redesign of work processes. An ominous implication of this analysis is that the sharp decline in IT investment growth rates in 2001-2003 may have been responsible for the decline in measured productivity growth 3-4 years later. In 2004-2006, productivity growth averaged only 1.3 percent. However, in 2007 and 2008 productivity growth nearly returned to its 1996-2000 rate, approximately 2.4 percent per year. If our hypothesis is correct, this may have been due in part to an increase in investment in IT that began in 2004.

The companies with the highest returns on their technology investments did more than just buy technology; they invested in organizational capital to become digital organizations. Productivity studies at both the firm level and the establishment (or plant) level during the period 1995-2008 reveal that the firms that saw high returns on their technology investments were the same firms that adopted certain productivity-enhancing business practices. The literature points to incentive systems, training, and decentralized decision making as some of the practices most complementary to technology. Moreover, the right combinations of these practices are much more important than any of the individual practices. Copying any one practice may not be very difficult for a firm, but duplicating a competitor’s success requires replicating a portfolio of interconnecting practices. Upsetting the balance in a company’s particular combination of labor and capital investments, even slightly, can have large consequences for that company’s output and productivity. As in a fine watch, the whole system may fail if even one small and seemingly unimportant piece is missing or flawed.

The unique combination of a firm’s practices can be thought of as a kind of organizational capital. We are beginning to see in the literature the first attempts to value this intangible organizational capital, which could be worth trillions of dollars in the United States alone. Some researchers use financial markets, some attempt to add up spending on intangibles, and others use analysts’ earning estimates to answer a basic question: How large are the annual investment and the total stock of intangible assets in the economy? For example, at the start of 2009 Google was worth approximately $100 billion but had only $5 billion in physical assets and about $18 billion in cash, investments, and receivables (according to balance-sheet information and financial-market data for December 31, 2008; total financial value is the sum of market capitalization and liabilities). The other $77 billion consisted of intangible assets that the market values but which are not directly observable on a balance sheet. Because the literature is not yet well developed, we expect to see more work in this area in the coming years. Various researchers have estimated that the annual investment in these intangibles held by US businesses is at least $1 trillion. A large portion of it does not show up in official measures of business investment. We see the attempt to quantify the value of these intangibles as a major research opportunity.

Producers of information goods face a major upheaval because of declining communication costs and because of