The Productivity Paradox &
Economic Evaluation of IT
Graduate School of Business
The University of Newcastle
18 August 1999
18/08/99
Heath Gibson,
. Dept. of Economics
Perspective
• Not aiming to give any definitive
'answers'.
• Rather to provide an alternative point of
view and approach to evaluating the
contribution of IT/IS.
• This will be set in the context of the
'productivity paradox'
What is the Productivity
Paradox?
• "You can see computers everywhere but
in the productivity statistics. " - Prof.
Robert Solow 1987.
• Strassmann argues that despite massive
IT investment, business costs have not
fallen and profits have not risen.
What is the Productivity
Paradox?
• Others (such as B&H) argue that IT
investment does improve productivity.
• Media 'hype' about technology extols the
virtues of IT and IT firms.
• This apparent contradiction between
what IT is supposed to do and its impact
on performance is the productivity
paradox.
Explaining the Productivity
Paradox
• Roach observed that in 70's and 80's
computing power per white collar worker
was increasing, but measured
productivity was declining.
• Strassmann observed that for top 60 US
industrial firms the ratio of Sales,
General &Administrative cost (SGA) to
Cost of Goods (COG) is worse than a
decade ago. Also observed no correlation
between IT spending and profits.
Explaining the Productivity
Paradox
• However B&H argue that IT spending has
improved productivity.
• How can these apparent contradictions
be reconciled?
It's all in what you measure
and how.
• Productivity refers to the ratio of outputs
to inputs.
• Thus, the choice of output or input
measure will influence the final result.
• A particular challenge relates to adjusting
for difference in quality, both in relation
to inputs and outputs.
The Research by Brynjolfsson
& Hitt
• B&H use economic theory to explore the
productivity paradox.
• Measure Output by (Gross Sales deflated
by output prices)
• Input measure was
IT Stock.
= Computer Capital + 3 * IS Labour
Brynjolfsson & Hitt
• B&H found that IT does make a positive
contribution to firms output.
• Also found IT has a positive net marginal
product after subtracting costs. I.e. the
net return on IT investment was greater
than zero
Brynjolfsson & Hitt
• But how is this reconciled with :
B &H results showing no correlation with
above normal profits;
Evidence such as that put forward by
Strassmann and Roach etc
Competition and Consumer
Surplus
• Economic theory of firm profit
Standard microeconomic theory: In a
competitive market, firms can only make
'normal' profit. That is, the firms revenue
will be just sufficient to cover its costs,
including providing a return to
shareholders.
Competition and Consumer
Surplus
• This occurs because the presence of
competition ensures that profits are
competed away until firms are making
'normal' profit. In industries where firms
make above normal profits, new firms
enter, increasing competition and driving
down prices.
Competition and Consumer
Surplus
• Thus, above normal profits can only be
made in the presence of barriers to entry.
Barriers to entry are restraints on the
entry of new firms into an industry.
Competition and Consumer
Surplus
• The analysis by B&H showed that IT
spending did not produce above normal
profit or increased share price. This
appears to conform to standard
microeconomic theory.
Competition and Consumer
Surplus
• So then where has all the improved
productivity gone?
The role of consumer theory.
The demand curve for a product shows
the amount of product a consumer is
willing AND able to purchase at a given
price.
Competition and Consumer
Surplus
• Consumer surplus is the difference
between what a consumer would have
paid for the product and the price
actually paid.
Competition and Consumer
Surplus
Competition and Consumer
Surplus
• The continual improvements in
computing power have led to a steady
decrease in the price of IT, though this in
part is offset by rises in associated costs
such as training and IT salaries.
• This decrease in costs and the positive
productivity of IT would suggest higher
profits?
Competition and Consumer
Surplus
• But consider the impact of competition!
 In the presence of competition the
benefits of IT to the firm are competed
away!
• Consumers gain since the lower prices
resulting from competition raise the
consumer surplus.
Competition and Consumer
Surplus
What are the lessons from
this?
• The strength of the economic framework
presented by B&H is that it provide an
integrated framework for explaining why
improved productivity may not lead to
improved profit.
What are the lessons from
this?
• But what then does this imply for
managers?
What are the lessons from
this?
• IT can both raise and lower barriers to
entry.
If a firms IT offers it a unique advantage
over its competition, it may be able to
earn above normal profit.
What are the lessons from
this?
• If there are other barriers to entry, a firm
may be able to exploit this advantage for
longer.
But if IT is not unique, it becomes a
'strategic necessity'. I.e. - it becomes
necessary to spend on IT in order to
remain competitive
What are the lessons from
this?
• IT can also lower barriers to entry by
reducing economies of scale and helping
to lower search costs.
• Therefore important to consider whether
a particular IT investment will raise or
lower barriers, or if it is necessary just to
stay competitive.
Valuing IT investment - The
Contribution of Strassmann?
• Aside from contributing to the
productivity debate, Strassmann has
helped to develop the idea of 'residual
value'. This is particularly of interest for
those who must evaluate an IT project
with a software component.
Valuing IT investment
• Some suggestions from Strassmann:
• Don't underestimate the useful life of the
system. If you investment is going to
become heavily integrated into your
business be prepared to take a longer
view.
Valuing IT investment
There is more to costs than just the initial
purchase price.
• installation, training and support costs
• maintenance
• cost of errors caused by users unfamiliar
with new system
• cost of training and organizational
change
Valuing IT investment
• Be aware though, your system will also
have a residual value once paid off.
• Many managers may expect a system to
show a return within too short a time
frame and when calculating the return of
the system may ignore the 'residual
value'
Residual Value
• The residual value is " the value of an
investment at the end of the planning
period ”.
Residual Value
Residual value includes:
• value of training gone into the system
• users familiarity with the system
• value of data stored in the system
Residual Value
• The residual value of an IT purchase
should therefore be deducted from the
cost. Spending which improves residual
value is thus being treated as an
investment in an asset rather than an
expense.
Improving Residual Value
• Retain 'supporting intelligence' e.g. reusable software. By retaining the same
interface and basic processes, less
training time is required than with
implementing a completely new package.
Improving Residual Value
• - Use similar interfaces and processes on
different applications. This maximises the
gain from training. E.g. consider the
Windows shortcut keys which are
common to almost all Windows
applications. Ctrl+C, Ctrl+V, Ctrl+Z
Improving Residual Value
• Build 'open system'. The core functions
of the system should be able to have
new OS's and hardware bolted on to
prolong life and raise residual value.
Improving Residual Value
• Importantly, old software should be
treated as an inheritance to be treasured
as it represents accumulated knowledge
of the business environment and
business processes.
Some other Insights from
Strassmann
• Strassmann also offers some
explanations about why hardware
improvements may not be improving
corporate IT performance.
• Bloated Software - extra hardware power
is 'gobbled up' by increasingly more
complex software.
• Excessive support costs. "The total cost
of ownership of a desktop computer now
includes as little as 10% for hardware
depreciation. Most costs are for
expensive support labor to keep the
hardware alive and to tranquilize
unhappy customers." Strassmann
• Negligent Systems Engineering - many IT
systems are put in place on an ad hoc
basis with little long term planning.
Corporate networks and systems may
resemble urban sprawl more than they
do a co-ordinated metropolis.
Some Closing Thoughts
• Some key issues which may be worth
considering then are:
Some Closing Thoughts
• Is there more to the cost of an IT project
than just the dollar cost of hardware and
software.
Consider whether a project will have
residual value? Could the residual value
be improved? Does allowing for residual
value make some projects now more
worthwhile than others?
Some Closing Thoughts
• Are there currently barriers to entry in
this industry?
• Will improvements in IT raise or lower
these barriers?
• Is a particular project a 'strategic
necessity'? Will it offer a 'unique
advantage'?
Some Closing Thoughts
• Finally, it is also worth considering
whether increasing consumers value
(consumer surplus) is important to the
organisations long term survival.