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The International Journal of Flexible Manufacturing Systems, 9 (1997): 145166

c 1997 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

The Information Technology Productivity Paradox

Revisited: A Theoretical and Empirical Investigation in
the Manufacturing Sector
ANITESH BARUA
Center for Information Systems Management, Department of Management Science and Information Systems,
Graduate School of Business, The University of Texas at Austin, Austin, TX 78712
BYUNGTAE LEE
Department of Management Information Systems, Karl Eller Graduate School of Management, The University of
Arizona, Tucson, AZ 85721

Abstract. The lack of empirical support for the positive economic impact of information technology (IT) has
been called the IT productivity paradox. Even though output measurement problems have often been held responsible for the paradox, we conjecture that modeling limitations in production-economics-based studies and input
measurement also might have contributed to the paucity of systematic evidence regarding the impact of IT. We take
the position that output measurement is slightly less problematic in manufacturing than in the service sector and
that there is sound a priori rationale to expect substantial productivity gains from IT investments in manufacturing
and production management. We revisit the IT productivity paradox to highlight some potential limitations of
earlier research and obtain empirical support for these conjectures. We apply a theoretical framework involving
explicit modeling of a strategic business units (SBU)1 input choices to a secondary data set in the manufacturing
sector. A widely cited study by Loveman (1994) with the same dataset showed that the marginal contribution of IT
to productivity was negative. However, our analysis reveals a significant positive impact of IT investment on SBU
output. We show that Lovemans negative results can be attributed to the deflator used for the IT capital. Further,
modeling issues such as a firms choice of inputs like IT, non-IT, and labor lead to major differences in the IT
productivity estimates. The question as to whether firms actually achieved economic benefits from IT investments
in the past decade has been raised in the literature, and our results provide evidence of sizable productivity gains
by large successful corporations in the manufacturing sector during the same time period.
Key Words: IT productivity paradox, production economics, input choices, marginal revenue product, manufacturing sector, input deflator

1.

Introduction

Even though worldwide investments in information technology (IT) have reached staggering
proportions, empirical evidence regarding the bottom-line benefits from such investments
remains tenuous at best. As suggested by a Business Week article (The Technology Payoff,
1993), in the 1980s, U.S. businesses alone invested $1 trillion in IT; the investment figure
for 1992 was nearly $160 billion (in constant 1987 dollars). Commonsense reasoning and
day-to-day observations suggest that IT has a tremendous potential to make organizations
more efficient, improve the quality of products and services, and spawn new businesses.
Indeed, IT has the fastest growing share of capital inputs. For example, the real investment
in information processing equipment as a share of real fixed business investment2 rose from

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around 9% in 1974 to 18.5% in 1984, to 37% in 1994. The WEFA group report (1994)
projects the share of IT to rise to 46.8% in 2003 and 55.6% by 2018. The real investment
in IT as a share of durable equipment rose from around 14% in 1974 to 30% in 1984, to
47.5% in 1994. The corresponding ratios of IT to industrial equipment were 42.5%, 125%,
and 210%, respectively.
Despite its intuitive appeal, investment in IT requires economic justification of benefits,
and studies investigating the productivity and business impact of IT have been unable to validate a consistent relationship between IT investments and firm performance. This dilemma
facing senior MIS managers and researchers was recognized by Roach (1987) as the IT
productivity paradox and was most aptly summarized by Solow (1987): You can see the
computer age everywhere but in the productivity statistics. Of course, computers are only
one component of IT. For example, the operational definition of IT capital for collecting
the data used in this study corresponds to the category Office, Computing, and Accounting
Machinery of the U.S. Bureau of Economic Analysis (BEA).3 According to this definition,
IT consists of computers, communications equipment, instruments, photocopiers, and related equipment (Bureau of Labor Statistics, 1983; CITIBASE, 1992). Software and related
services are considered separately.
Measurement problems largely have been held responsible for the seemingly lackluster
returns from IT. For example, Gordon (1989) and Baily and Gordon (1988) point out potential problems with output metrics that do not capture quality impact of IT. The WEFA group
report (1994) also emphasizes the problem of coming up with suitable output measures:
The development of the personal computer and subsequent quality improvements have
fueled this explosion in information processing equipment. The mystery is why this
massive computer investment has not resulted in measured productivity gains in the
service sector. It is very difficult to measure output in many service sectors and inputs
are used as a proxy for output, which by definition, will constrain productivity gains.
While measures such as output volume or its value cannot capture the potentially large
impact of IT on product and service quality, we believe that simple efficiency gains can
still be assessed through conventional output measures. Intuition would suggest that the
manufacturing sector has achieved significant productivity improvements through basic
IT applications in inventory management, scheduling, capacity planning, purchasing raw
materials, process monitoring, and quality control. For example, the benefits of mature
systems such as materials requirement planning are well documented:
1. Turnover increase, lead-time reduction, reduced material waste (Cerveny and Scott,
1989; Schroeder, Anderson, Tupy, and White, 1981; Yeo, Ong, and Wong, 1988).
2. Coordinated purchasing, inventory management, and production planning, which reduces delays and improves the ability to meet deadlines and delivery schedules (Duchessi,
Schaninger, Hobbs, and Pentak, 1988).
3. Reduction in costly emergency orders (Schroeder et al., 1981).
4. Fewer out-of-stock conditions, which would adversely affect scheduled production. Outof-stock situations may further require expediters and lead to inefficient rescheduling of
production as well as split orders (Schroeder et al., 1981).

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5. Better management of financial and personnel resources (Duchessi et al., 1988; Senn,
1990).
Each of these benefits of materials requirement planning systems can be translated into increased output, everything else remaining constant. For example, an out-of-stock condition
for raw materials implies that the machines are idle and extra output could have been produced during this idle period. Output measures in the manufacturing sector are slightly less
problematic than those in the service sector (although we certainly do not imply that qualityadjusted output is easy to derive even in the manufacturing sector). Although more recent
IT applications in the areas of flexible manufacturing, just-in-time inventory management,
and CAD/CAM create the potential for more spectacular gains, the lack of positive results
involving the manufacturing sector appears to be an artifact of the productivity assessment
technique.
We address two additional issues (other than output measurement) that might have added
to the productivity estimation problem. The first involves the modeling approach usually employed in MIS research on productivity measurement. We take the position that productionfunction-based MIS studies have not exploited the fundamental theoretical foundation of
production economics involving profit maximization or cost minimization. Second, input
measurement issues dealing with the very definition of IT might have led to disappointing
results in a widely cited and influential study by Loveman (1994). As we have stated previously, IT consists of much more than just computers and using a deflator corresponding
to computer capital will overdeflate the IT input because of dramatic improvements in the
price-performance ratio for computers and peripherals. These theoretical and measurement
issues provide the motivation for this study.
Based on a production theory model of profit maximization, we analyze the productivity
gains from IT investments in the manufacturing sector using different functional specifications. We use the same data set deployed by Loveman and show that IT had a very significant
positive impact on the productivity of strategic business units in the sample. According to
our results, the average marginal contribution of IT capital to revenue product was 74%.
The significant positive impact of IT is consistent across model specifications (e.g., CobbDouglas and translog production functions). The contribution of this paper is twofold. First,
it raises a concern for a theoretical modeling issue in IT productivity studies and provides
empirical evidence in support of the concern. Second, it shows that input measurement
problems can be attributed to the disappointing IT productivity estimates in an important
prior study.
The balance of the paper is organized as follows. Modeling issues and some productioneconomics-based studies of IT productivity are reviewed in the next section. Section 3
provides the theoretical model involving input choices facing a firm. Two basic hypotheses
also are formulated in this section. The data set and measurement issues are discussed in
Section 4. Model estimation and results are presented in Section 5. Limitations and future
research are outlined in Section 6. We conclude in Section 7.
2.

Relevant literature and motivation

Studies focusing on the economic impact of IT investments generally can be classified

into two categories: production function based and business value modeling. The latter

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involves tracing and measuring IT impacts on various performance metrics through a web
of relationships, which often include organizational variables (e.g., see Barua, Kriebel, and
Mukhopadhyay, 1995; Dos Santos, Peffers, and Mauer, 1992; Kauffman and Kriebel, 1988;
Weill, 1992, for various business-value-oriented models). In this paper, however, we focus
on a set of studies using the production economics approach.
Production-theory-based studies use parametric specifications for the technology that
converts inputs to outputs. With two recent exceptions involving a common dataset, however, most other studies have failed to provide evidence of significant productivity gains
from IT investments. For example, Morrison and Berndt (1990) find that a $1 investment in
IT contributed $.80 of additional value. Roach (1987) reports disappointing results involving the productivity of information workers. Along similar lines, Baily and Chakrabarti
(1988) suggest the absence of significant productivity gains from IT investments. One of
the most important and influential studies of IT productivity at the SBU level is that of
Loveman (1994). Loveman investigated IT productivity in the manufacturing sector for
the time period 19781984 and concluded that the marginal dollar spent on IT would have
been better spent on non-IT inputs to production. However, using the same data set with
a business value approach, Barua et al. (1995) showed that IT was positively related to
intermediate level performance measures such as capacity utilization, inventory turnover,
quality, relative price, and new product introduction; also, these intermediate variables were
predictors of higher level measures such as return on assets and market share.
Recently, two studies (using a common data set) have found significant productivity
gains from investments in computer capital. Using data collected by the International Data
Group, Brynjolfsson and Hitt (1993) and Lichtenberg (1993) find large positive returns
from computer capital. This is encouraging news for MIS academics and professionals, but
on the balance, the evidence of IT productivity still is mixed at best. Note that computer
capital is only a subset of the broad IT category. Are the returns from IT comparable to
those from computers? Further, Brynjolfsson and Hitt (1993) remark: Because the models
we applied were essentially the same as those that have been previously used to assess the
contribution of IT and other factors of production, we attribute the different results to the
recency and larger size of our dataset. By focusing on the recency aspects, implicitly
Brynjolfsson and Hitt (1993) are questioning whether firms actually obtained economic
benefits from their IT investments in the earlier phases of computing. We use Lovemans
data set to analyze whether the real paucity of IT productivity gains or measurement issues
led to the negative results.
Measuring inputs and outputs are two key limitations of the production economics approach. In the service sector, the definition of output itself can pose significant problems.
For example, Gordon (1989), Baily and Gordon (1988), and Brynjolfsson (1993) discuss
the limitations of the approaches used by the Bureau of Economic Analysis, which, they
suggest, underestimate productivity. Fortunately, defining output is a little easier in the
manufacturing sector. Of course, conventional production economic measures of output
cannot easily account for improvements in product quality or the creation of new products
and also are likely to underestimate IT productivity.
Having stated the limitations of the production approach and its attendant measurement
issues, it is equally important to state its positive features. It provides a normative framework

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to understand how firms behave with respect to input and output markets and the technology
of transforming inputs and outputs. From an operational standpoint, sophisticated econometric techniques can address issues that arise in conjunction with the estimation of the
theoretical models.
We believe that most MIS studies on IT productivity have not taken the theoretical
route. Unless the behavior of the firms in setting inputs, outputs, and prices (where applicable) is explicitly modeled, we are not utilizing the theoretical premise of the production
economics framework. In other words, apart from some assumptions about possible substitutions between the various inputs, no theory stands behind the estimation of a single
production function.
In this research, we seek to establish (apart from other things) that estimating production functions without modeling input and output choices can lead to misleading productivity figures. Second, we investigate the deflators for IT capital. How different are
they from the deflators used for computer capital? How does the choice of the deflator
affect (if at all) the IT productivity estimates? By addressing these modeling and estimation issues, we expect to get deeper insight into the very nature of the IT productivity
paradox.

3.

Production-economic-based assessment of IT impact

IT productivity assessment studies using production economics generally involve the estimation of a Cobb-Douglas or translog production function (e.g., Loveman, 1994; Brynjolfsson and Hitt, 1993). However, microeconomic production theory is based on the premise
of profit maximization or cost minimization. A production function represents the underlying production technology, a specification of how inputs can be combined to produce
output; it does not involve input and output prices or how a firm or SBU should choose
its input and output levels. Much of production economics is concerned with the optimal
choice of inputs (and outputs, where applicable). That is, the estimation of a production
function without modeling how firms choose their inputs or outputs is not consistent with
the theoretical foundation of production economics.
Suppose there are N inputs to a firms production process. Given a competitive market
output price, p, and a N -dimensional input price vector, w = (w1 , w2 , . . . , w N ), a firm
can maximize its profits by choosing the optimal output quantity, q, and input quantities
x = (x 1 , x2 , . . . , x N ). When the production capacity is inherently limited (e.g., in the
electric power supply business), firms minimize production costs for a given output quantity.
In this paper, we restrict our focus to the profit maximization perspective. If the quantity (q)
of output produced is given by a production function, f (x), then the profit maximization
problem is given by

max

x=(x1 ,x2 ,...,x N )0

p f (x)

N
X
i=1

wi xi .

(1)

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Specific functional forms

We start the analysis with a Cobb-Douglas specification for the production function f (x)
with a disembodied technological change rate, ,
q = Aet

N
Y

xii ,

i=1

which, after a log transformation yields a linear form,

ln q = 0 + t +

N
X

i ln xi + ,

(2)

i=1

where is a random error term. Because a firm can choose its input mix (based on the input
and output prices), instead of directly estimating the production function, we obtain a set
of N equations (one for each input) as first-order conditions for profit maximization. The
first-order condition for ith input (i = 1, 2, . . . , N ) is
wi = p Aet i xii 1

N
Y

xj j.

(3)

j=1

After a log transformation, we obtain

ln(wi / p) = ln q + ln i ln xi .
This first-order condition suggests that the unit price of the ith input (i = 1, 2, . . . , N ) must
equal the value of the marginal product for the ith input. Thus, the profit maximization
framework results in a system on N +1 equations, one for the production function, and N for
describing the behavior of the firms in choosing N inputs. The system of equations implies
that, except under very restrictive conditions, estimation techniques such as ordinary least
squares cannot be used to estimate the parameters of interest. More significant, it has an
important implication for the underlying nature of the inputs. This is discussed next.
3.2.

Endogeneity of inputs to production

Using a profit maximization (or cost minimization) framework suggests that the input
quantities are endogenously determined within the model, and the output and input prices
are the exogenous variables. This is in direct contrast with the single equation method
usually employed in IT productivity assessment. For example, in Lovemans (1994) and
Brynjolfsson and Hitts (1993) models, expenditures on inputs such as IT and labor are
exogenous variables.
When a firm is technically efficient and achieves scale efficiency (i.e., produces the
optimal quantity of goods), it can achieve profit maximization only when it chooses the best
input mix, which gives the lowest production cost. The best mix of inputs is the point where
its production frontier and iso-cost curve meet (this choice is represented by the first-order

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conditions for various inputs). Thus, production theory provides a clear basis for assuming
a priori that the inputs are endogenous. Accordingly we state our first hypothesis.
H1: The inputs to production are endogenous. The significance of this hypothesis is
that, if empirically supported, it would require IT productivity to be measured as a system
of equations (using some technique that provides consistent estimates) as opposed to the
single equation generally employed in the MIS literature. As we have emphasized earlier,
this endogeneity assumption is the very basis of production theory, but surprisingly has
received little attention in MIS studies. A well-known result in econometrics (e.g., see
Christensen and Greene, 1976; Schmidt and Knox Lovell, 1979; Kumbhakar, 1987), is
that estimating the production function without modeling the firms input choices provides
consistent estimates of the parameters only when the inputs truly are exogenous. In other
words, unless the firms have no choice over how much of each input they use in production,
the preceding estimation will lead to inconsistent results. Because data often are collected
at the SBU or firm level, they represent micro-level observations. Whereas exogeneity of
inputs may be assumed during the model specification phase for economywide data, it is
difficult to provide a theoretical rationale for such an assumption in the case of micro-level
observations.
3.3.

Translog functional form

Because the Cobb-Douglas production function has some restrictions, like perfect substitution among inputs, more general forms, such as the translog and quadratic functions, have
been suggested as alternatives. We choose a translog production function because it imposes
minimal a priori restrictions on the underlying production technology and approximates a
wide variety of functional forms. The translog function is given by
ln y = 0 +

k
X

i ln xi + t t

i=1

k
X
i=1

ti t ln xi + 1/2

k
k X
X

)
i j ln xi ln x j + tt t

+ ,

(3)

i=1 j=1

where is the random error term.

Berndt and Wood (1975) provide the revenue share equation of the ith input (after a log
transformation):

!2
N
X
i j ln x j + ti t .
(4)
ln xi ln q + ln(wi / p) = 1/2 ln i +
j=1

The production function (3) and the revenue share equations (4) can be estimated by the
full information maximum likelihood (FIML) method. Also, as in the case of the CobbDouglas formulation with profit maximization, q and x are endogenous variables, but p
and w are exogenously specified.4

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Contributions of IT investment

3.4.1. Productivity measures. The production function estimation technique is based on

the total factor or multifactor productivity, which is defined as output divided by some
combination of input variables. Mathematically it is represented as y/g(x), where g(x)
specifies how the inputs x are combined (Bodea, 1994; Grosskopf, 1993). We are more
interested in knowing the productivity contribution by a single factor such as IT. This is
given by the elasticity of total production with respect to the ith input: Ri = f (x)/ xi .
This elasticity, Ri , is positive for a productive input.
3.4.2. Marginal revenue product. Rather than calculate the contribution of an input toward
the output quantity, it is more interesting to determine the revenue contribution that the
additional output can make (if the firm can sell the additional output at the given price).
The marginal revenue product (MRP) with respect to an input is the value of the additional
output that would be produced from increasing the input by one unit. Also, instead of using
the physical input quantity, we ask the question, if we invest an additional dollar in IT, by
how much will it increase the revenue product? From Eq. (2), the MRP contribution of the
investment in the ith input is given by

i pq
( pq)
=
= Ri p/wi .
(5)
(wi xi ) q,xi , p,wi
wi xi
3.4.3. Marginal revenue product and profitability. It is important to note that a positive
productivity contribution from an input (measured in this paper by Eq. (5)) does not necessarily imply increased profitability or better financial performance. According to Douma
and Schereuder (1992), firms try to maximize profit or minimize costs under given market
conditions. However, in highly competitive markets, a firm may be forced to pass on the
IT-generated benefits to the consumers (say, in the form of lower prices) due to competition. Such analysis is beyond the scope of the traditional production economics framework.
Even when an additional investment in IT (or any other input) does not lead to increased
profits, it is still in the best interest of the firm, as long as it increases the MRP. The firm must
seek the best mix of inputs to make the production process efficient, because not doing so
may carry a heavy opportunity cost. This relates to the notion of IT as a strategic necessity
(Clemons and Kimbrough, 1987; Barua et al., 1991), which suggests that, although IT may
not be a source of competitive advantage (i.e., not lead to consistent above-normal returns),
firms have to invest in IT to remain competitive.
3.4.4. Marginal revenue product of IT. This productivity measure has the limitation that
it does not consider quality improvements brought about by an input such as IT. In the
introduction, we alluded to this problem. However, even when an output measure does
not reflect changes in quality, we still would expect to see significant gains in the SBU
output from IT investments. Let us consider some examples that would fit the computing
applications during the time period covered by the study (19781984).
A major fraction of IT investments typically would involve transaction processing and
shop-floor automation systems. For example, if an investment is made in numerically

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controlled machines, we would expect a given amount of labor to produce more output.
By investing in scheduling systems, we can reduce slack time, which can translate into
increased output, ceteris paribus. Electronic monitoring of labor productivity also will lead
to increased output. Shop floor automation projects will help supervisors locate faulty
machines or parts faster, leading to increased output, ceteris paribus. For example, shopfloor control systems, although less sophisticated than computer-aided manufacturing, provide on-line real-time control and monitoring of machines (Martin, Dehaoyes, Hoffer, and
Perkins, 1991). IT for quality and process control increases the output quantity without
defects. These scenarios may appear naive compared to the complex quality, demand, and
pricing issues (and their strategic implications) associated with modern applications of IT,
but they indicate that we should find significant productivity gains from IT investments in
the manufacturing sector.
Anecdotal evidence of IT productivity in the manufacturing sector abound the MIS
literature. For example, through IT applications Deere and Company was able to reduce
its break even point by 50% in 10 years and also reduce space and machine investments
(Martin et al., 1991). By adopting group technology, Deere was able to significantly reduce
setup time and lead time for parts production (Vonderembse and White, 1988). In 1983,
Omark Industries, Inc., developed the zero inventory and production system for inventory
management. Apart from annual savings of $7 million on inventory holding costs, Omark
achieved remarkable improvements in material movement, work-in-process inventory, and
lead time (Vonderembse and White, 1988). All of these impacts translate into increased
output. These observations provide the rationale for the following hypothesis.
H2A: The contribution of IT investment to the marginal revenue product is positive. What
can we expect regarding the relative contributions of IT and other inputs such as labor and
non-IT capital? For nearly 100 years, over 60% of the annual increase in productivity in
the United States was attributed to management, while labor and equipment contributed
approximately 20% each (Heizer and Render, 1988). Management involved the use of
technology and knowledge, and early advances in IT created the potential for managing
production processes and inventories in an efficient manner. Even manufacturing processes
started becoming more information intensive (processes in the service sector naturally were
information intensive), while blue-collar labor intensity got reduced. Building on the same
theme, we suggest that, on an average, the amount of computing that we can buy for $1
should contribute more to output, ceteris paribus, than the amount of labor that can be
obtained for $1. Based on this discussion, we state our hypothesis regarding the relative
contribution of IT, labor, and non-IT capital.
H2B: IT contributes more to the marginal revenue product than non-IT capital and labor.
4.
4.1.

Data and measurement issues

Data description

The data used in this study was provided by the Strategic Planning Institute (SPI), Boston. It
is referred to as the management productivity and information technology (MPIT) database

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and contains data on corporate balance-sheet items and organizational variables on about
60 SBUs5 from 1978 to 1984. The SBUs belong to large corporations involving various
manufacturing sectors such as consumer products, components, and raw or semi finished
materials. Excluding missing variable cases, we have 47 SBUs with a total of 231 observations. Further, the busineses units are observed for some consecutive years, starting and
ending in different years.
The MPIT database reports IT capital and purchased IT services separated from other
capital investments, which enables us to investigate the impact of IT investments. IT
equipment consists of communications, computers and peripheral equipment, word processing reprographics, facsimile, and science and engineering instruments. Purchased IT
services include information services, databases, software, communications services, and
reprographics services. The data set also contains a summary of balance-sheet and income
statements. It reports labor input, land and plant capital stock, non-IT equipment capital
stock, and IT capital stock as well as inventory and expenditure for non-IT and IT service.
The data were self-reported by the participating SBUs and checked for consistency by
the SPI staff. Time series and other statistical analysis were also performed by SPI. The
participating companies received specific reports comparing a business (or group of business) to these average findings as well as to its own unique benchmarks. Additional details
of data collection procedures and data quality issues for the MPIT database are discussed
in Loveman (1994).
Although the MPIT data set dates back to the late 1970s and early 1980s, re-examination
of the data can provide valuable insight into the nature of the productivity paradox. For
example, are Lovemans results indicative of the absence of positive productivity impact
in Fortune 500 manufacturing organizations or can they by attributed to some aspect(s) of
measurement and analysis?
The scope of computing in organizations has been enhanced dramatically over the last
decade. Fueled by the explosion in local and wide-area networking, creative applications
of IT to enhance quality, customer service, and intra- and interfirm coordination have
widened the potential for very high impact from IT investments. Ironically, however, the
complexity of the IT architecture and applications also has made it equally difficult to assess their economic impact in empirical studies. On the output side, the MIS researcher
has to come up with economic measures that capture the quality changes brought about
by IT. The proliferation of networking and the shift in the computing paradigm from centralized mainframes to client-server architecture make it extremely difficult to accurately
measure the input side of the productivity equation. A large fraction of the IT capital input
today would consist of network-related investments, without which the end-user computers will not accomplish any productive task. So, although some recent studies on IT
productivity have focused on the return from computer capital, we argue that investments
in networking are complementary to investments in end-user computers such as PCs and
workstations and that we even may obtain misleading results by ignoring the networking factor. In other words, measuring IT productivity today may be more complex than
with the MPIT data, because the computing scenario then was dominated primarily by
mainframes.

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Table 1.

4.2.

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Derived input prices.

Inputs

Mean

Standard deviation

Structure

1.50

0.73

Non-IT

1.32

0.59

IT capital

1.66

0.65

Inventory

1.82

0.93

Input quantities and unit prices

The total labor cost and quantity (converted to the number of full-time employees) were
available in the MPIT database.
The next step in our productivity analysis involves the derivation of quantities and prices
for capital inputs. Capital input is defined as services from physical assets (Bureau of Labor
Statistics, 1983). The capital stock of a depreciable asset (such as IT) is proportional to
the services from that asset. The total current services from an asset are proportional to
the productive stock, which is the amount of new investment required to provide the same
services actually produced by existing assets. We get an approximation of the productive
capital stock from the wealth stock, which represents the present value of all future services
embodied in existing assets and reflects the current market value of new and used capital
goods.
We apply economic depreciation rates instead of the reported (accounting) depreciation
rates to derive the price of capital services according to the methods developed by Christensen and Jorgenson (1969). We use the perpetual inventory method to derive the stocks
of IT, non-IT equipment, structure, and inventory. Further, because all data in the MPIT
data set are end-of-the-year figures, we apply the half-year convention for depreciation
and the calculation of the productive stock. In deriving input prices, we follow the Bureau
of Labor Statistics (BLS) method (1983), which itself is based on the work of Christensen
and Jorgenson (1969). The formulas used in the calculation of input prices (values of wi )
are provided in the Appendix to this paper. Outlier analysis revealed two SBUs with extreme values. The average input prices and their standard deviations are shown in Table 1.
Because the MPIT data set reports purchased IT services separately, we follow the BLS
convention of multiplying the purchases by the average life expectancy (see Table 6 in the
Appendix) and adding the result to the IT capital stock. As an alternative to this approach,
we also performed the analysis by assuming that all IT purchases should be treated like pure
capital, whereby the purchases are directly added to the IT capital. However, the estimated
IT contributions using the two different capitalization methods are very close, showing that
the results are robust with respect to the capitalization methods.
4.3.

Output quantity and price

The MPIT data base contains the relative price (as a percentage of the weighted average
price of three largest competitors, with price parity = 100). We match the MPIT industry

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definitions with those used by the U.S. Department of Labor and BLS. Industry output
price indices are obtained from GNP industry-specific producer price indices in CITIBASE.
The output prices for SBUs are derived from the average industry price index and the relative
price. The output quantity is obtained as revenue less inventory changes, deflated by the
derived output price.
5.

Model estimation and results

We first present estimation results for the Cobb-Douglas function with exogenous inputs.
We then compare the results with those obtained from the optimization model. Next, we test
the sensitivity of the results with a different functional specification. Finally, we compare
our analysis and results with those of Loveman.
5.1.

Nonoptimization versus optimization

Table 2 shows the estimation results of the Cobb-Douglas formulation under the assumption
of nonoptimization. That is, these estimates are based on a single equation specifying
the production technology. We used ordinary least squares (OLS) to estimate the model.
Note that IT shows a significant positive impact. However, other key inputs like non-IT,
inventory, and labor do not contribute significantly to the output. This raises a concern about
the consistency of the estimates, because the data come from large successful organizations,
where inputs like labor and non-IT capital would be expected to lead to more output. To
address this issue, we present the results of the optimization model with the Cobb-Douglas
function in Table 3. Note that the input variables now are assumed to be endogenous (i.e.,
their optimal levels are determined by the input and output prices) based on the first-order
conditions in Section 3.1 and the subsequent discussion of endogeneity in Section 3.2. The
optimization model was estimated with the full information maximum likelihood method.
Table 2. Productivity model estimation
with exogenous inputs.
Parameter

Estimate

T -statistics

Constant

1.311

3.36

Labor

.171

1.96

Structure

.130

2.34

Non-IT
IT

.064
.683

.79
6.40

Inventory

.072

.32

Time trend

.035

1.22

Adjusted R 2 = .927.
p < .1.
p < .05.
p < .01.

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Table 3. Productivity model estimation

with endogenous inputs.
Parameter

Estimate

Constant

9.30

T -statistics
29.99

Labor

.291

22.21

Structure

.086

10.34

Non-IT

.372

11.40

IT

.147

34.01

Inventory

.101

3.07

Time trend
p

.028

1.12

< .01.

The results are quite different than those from the nonoptimization model. In the system
of equations involving the input choices facing the SBUs, all non-IT inputs are highly
significant, as normally would be expected in production function estimates.
5.2.

Are the inputs endogenous?

The results for both optimization and nonoptimization models show significant positive
impact capital investment in IT. The question is whether both sets of results are consistent.
The nonoptimization framework attempts to fit the data into the model without considering
how the firms choose the input mix based on input prices. In other words, that input quantity
variation among business units can be a rational decision based on differential input prices
facing the business units is ignored in the estimation, and the estimates are based solely on
how well the input and output quantities fit the specified production function.
As we already have noted, the coefficients in the nonoptimization model indicate some
potential problems involving the nature of inputs. Of course, we can investigate the endogeneity issue econometrically. We use Hausmans (1978) specification error test to seek
the validation of hypothesis H1. This test involves two sets of estimators. The first set
of estimators is efficient (or more efficient) and consistent under the null hypothesis (the
inputs are exogenous) but is inconsistent under the alternative hypothesis. The second set of
estimators is consistent under both hypotheses but is not efficient under the null hypothesis.
These conditions are exactly satisfied by the OLS estimates of the single production function
(nonoptimization) model and the maximum likelihood estimates of the optimization model.
The Hausman test statistic has a 2 distribution with N degrees of freedom, where N is
the number of parameters. The statistic obtained is 121.75***. Therefore, our hypothesis
regarding the endogeneity of inputs is verified, implying that not considering the choice of
inputs would lead to inconsistent parameter estimates.
5.3.

How much did IT contribute to output?

The testing of hypotheses H2A and H2B requires that we find the impact of unit investment
in IT and other inputs on the revenue product. In other words, we have to use input and

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Table 4. Contribution of labor, non-IT, and IT capital to
revenue product.
Contribution (%)
Revenue
p

Labor

Non-IT

IT

60.68

58.92

74.27

< .01.

output prices to obtain the MRPs with respect to IT capital and other inputs. The MRPs
are shown in Table 4. The contribution of IT to the revenue product is very significantly
positive. Therefore, hypothesis H2A is verified. Note that revenue product is conceptually
different from the actual revenue generated by the firm. The revenue product is the dollar
equivalent of a quantity of output. For example, if increasing a particular input by $1 results
in an increase in the output by 1% and the unit price of the output is $200, then the value
of the additional output is $2. However, whether or not the firm or SBU can increase its
revenue by $2 by investing an additional $1 in an input depends on whether it can sell
the product in the market at that price. Because we did not endogenously model market
behavior with respect to the output (we assumed the SBUs to be competitive), it would be
unwarranted to claim the preceding figures as the contribution of IT and other inputs to a
SBUs revenue.
It is also important to note that we have reported the average MRPs for the sample.
Further, the MRPs for each SBU were calculated at their current levels of IT and other
input investments. In other words, their MRPs would have been even higher if they were
calculated at lower levels of input investment.
Did IT contribute more to revenue product than labor and non-IT capital? A comparison
of the contribution means with t-tests suggests that IT contributed significantly more than
labor and non-IT capital (both differences significant at p < .01). Thus, hypothesis H2B
also is verified.
Having obtained empirical evidence supporting the two hypotheses involving input endogeneity and MRP, we investigate whether the results are robust with respect to the functional
form used in the study.
5.4.

Do the results change with model specification?

As noted earlier, the Cobb-Douglas function has some inherent restrictions. To test the
sensitivity of the results obtained with the Cobb-Douglas functional form, we use a translog
production function with its own set of profit share equations. The coefficients in a translog
production function are not meaningful, like the coefficients in a Cobb-Douglas function.
What matters in a translog function is the implied elasticity of the output with respect to
each input. The implied output elasticity with respect to IT is calculated to be .177, which,
along with the input and output prices, imply an IT contribution of 78.76% to revenue
product. Note that this is close to the 74.27% contribution obtained with the Cobb-Douglas
form.

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Why did Lovemans study find a negative impact?

We started with a conjecture that the MPIT data, coming from large successful organizations,
did have a significant positive contribution from IT and that measurement and modeling
issues might have contributed to the negative results obtained by Loveman. We already
have shown that modeling differences (e.g., assumptions of endogeneity and exogeneity
of inputs) can lead to significantly different results. In this subsection, we investigate the
measurement issue. In replicating Lovemans results, we discovered a striking difference
between the IT deflators employed in our and Lovemans studies. Loveman used the BEA
quality-adjusted computer price index to deflate IT investment. This choice is appropriate if
IT consisted only of computers. However, the MPIT definition of IT corresponds well with
the BEA category Information Processing and Related Equipment. BEAs classification of
Producers Durable Equipment (IPRE is one category within this group) is as follows:
Information processing and related equipment
Computers and peripheral equipment
Office, computing, and accounting
Other office computing equipment
Communication equipment
Instruments, science and engineering
Photocopy and related equipment
Industrial equipment
Transport and related equipment
Other.
Note that computers are included only in the subcategory Computers and Peripheral
Equipment. As we would expect based on these subcategories, there are major differences
between the IPRE deflator we used in our study and the price index of computers. The IPRE
deflators are shown in Table 5. As an illustration, in 1977, the BEA implicit price deflator
of IPRE was around .79, while the price index of computers (office and storage machines)
Table 5. Implicit price deflators
for IPRE.
Year

IPRE

1977

0.79497

1978

0.83078

1979

0.86795

1980

0.92201

1981

0.99998

1982

1.04609

1983

1.06559

1984

1.06477

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was 3.27. In 1984, the corresponding figures were 1.06 and 1.60, respectively. Thus, using
the computer price index under the assumption of IT as consisting only of computers results
in too much deflation.
In its description of the MPIT database, the Strategic Planning Institute states that the
definition used in collecting the IT data corresponds to the IPRE category. In addition to the
definition of IT, indirect evidence suggests the IT investments reported in the MPIT data set
involve more than computers. Computer capital constitutes about 1% of revenues in recent
times (Brynjolfsson and Hitt, 1993). We found that IT constituted about 2.3% of revenues
in 1978 and increased to 2.92% in 1982. Thus, using Brynjolfsson and Hitts 1% figure
for investment in computers, noncomputer and peripheral categories of IT constituted 1.3
to 1.92% of revenues. It implies that the manufacturing companies included in the sample
spent more on noncomputer and peripheral equipment categories of IPRE than on computers and peripheral equipment. It is not surprising that categories like communications
equipment and especially instruments for science and engineering would involve significant
investments in the manufacturing sector. Given that the prices of these categories do not
change at the same rate as computers, deflating these investments with a computer price
index in conceptually incorrect.
The preceding discussion does not imply in any way that the BEA deflators are accurate.
Such deflators have their share of problems, including the inability to reflect important
changes is quality and features of technologies. We take the position that, because the
operational definition of IT in the MPIT data set corresponds to the IPRE category, it would
be natural to choose the IPRE deflator (in spite of the well-documented limitations of any
capital input deflator) rather than a computer price index.

6.

Limitations and future research

A study dealing with a complex problem, such as productivity analysis and its results
cannot be properly interpreted without a discussion of then methodological and data-related
shortcomings.
6.1.

Methodological issues

With its focus on input and output quantities, production economics does not directly address
the issue of quality improvement. For example, if an input such as IT improves product
quality instead of quantity, such a change would not be captured in the simple production
theory framework. Further, we need richer models that explain the processes through which
IT creates its impact. The production function method takes a black-box orientation (Barua
et al., 1995). Business-value-oriented approaches have been adopted by many authors to
address this limitation.
A second methodological limitation stems from the assumption of a competitive, exogenously specified output price. For example, the price may be dependent on the quantity
produced (Kreps, 1990) as well as on more complex factors such as product differentiation.
In the case where the price depends on the quantity produced, the optimization problem in

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Eq. (1) becomes

max

x=(x1 ,x2 ,...,x N )0

p( f (x)) f (x)

N
X

wi xi

i=1

and the first-order condition for input i is

wi = { p 0 ( f (x)) f (x) + p( f (x))}

f (x)
.
xi

While relaxing the assumption of a competitive firm brings in additional complexity in

estimation, sequel research should focus on the potentially endogenous nature of the output
price.
Another useful area of research would involve empirical investigation of complementarity between IT and other inputs. In the economics literature, Milgrom and Roberts (1990)
use complementarity to explain the simultaneous adoption of complementary strategies in
modern manufacturing. In the MIS literature, Barua, Lee, and Whinston (1995) recognized the complementarity between incentives, team and task characteristics, and system
design features. Barua, Lee, and Whinston (1996) use complementarity theory to develop
a foundation for assessing the value of business process reengineering. Empirical testing
of complementarity between IT and non-IT factors can provide critical insights into the
productivity paradox.
6.2.

Data related issues

Like most secondary data sets, the MPIT data do not provide information on the type of
computing environment (although it is likely to be dominated by legacy systems) or the
nature of the application (e.g., inventory control versus payroll). Such finer partitioning of
the data would have enabled a deeper understanding of the nature of the impact by IT.
We have some evidence of significant positive contribution of IT investments to productivity, but the SBUs in the data set are by no means typical of the manufacturing sector at
large. These SBUs belong to the elite Fortune 500 group and, therefore, by definition, are
large successful entities. They naturally are expected to manage their resources better than
a typical manufacturing SBU. However, earlier research indicated that even this special
group had failed to exploit their IT investments; out study finds support for the conjecture
that these SBUs are most likely to achieve large productivity gains from their IT (and other)
investments.
Given the dramatic improvements in the price-performance ratio of desktop computers
and the large-scale deployment of computing applications in the manufacturing sector, the
analysis of more recent data sets may show even more positive productivity contribution
from IT investments. Whether such productivity improvements lead to competitive advantage is an open question, based on our discussion of strategic necessity in Subsection 3.4.3.
7.

Conclusion

As organizations continue to increase the IT share of capital stock, the productivity figures keep eluding MIS researchers. Although there are many approaches to assessing the

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economic benefits of IT, some of the often-quoted studies are based on the production function framework. We address some theoretical issues in production economics, and suggest
a potential limitation of the modeling technique used in MIS productivity studies. Further,
we provide empirical evidence that the choice of the input deflator led to negative results in
an important prior study. The absence of systematic evidence regarding IT productivity has
prompted some researchers to question the gains from IT investments in the earlier phases
of computing, but our results indicate that very significant productivity gains were realized
by large corporations in the manufacturing sector during the time period covered by the
study. Despite several limitations to our study, we replicate the significantly positive contribution of IT using two different model specifications and estimation techniques. Our sequel
research in this area will focus on assessing the efficiency impacts of IT in the same data set.

Appendix: Calculation of capital input prices

For producers durable equipment (IT and non-IT capital in this paper), the price of capital
services is given by
wt =

1 u t z t et
{qt rt + qt t (qt qt1 )} + qt xt ,
1 ut

where
u t is the corporate income tax rate,
z t is the present value of $1 of tax depreciation allowances,
et is the effective rate of the investment tax credit,
rt is the nominal rate of return on capital,
t is the average rate of economic depreciation,
qt is the deflator for new durable equipment capital goods (from BEA),
xt is the rate of indirect taxes.
For structures held by a corporation, the price of capital services is
wt =

1 u t zt
{qt rt + qt t (qt qt1 )} + qt xt ,
1 ut

where qt is the deflator for structures.

For nonfarm inventories held by a corporation, the price of capital services is
wt =

qt rt (qt qt1 )
+ qt x t ,
1 ut

where qt is the deflator for inventories. The detailed procedures for calculating u, z, e, r, ,
and x are shown next.

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Depreciation rates for capital inputs.

Type of asset

Life (year)

Depreciation rate

15

.133

Non-IT capital
IT capital
Nonresidential structures

.250

30

.0667

Economic depreciation rate (t )

The BEA reports 47 types of assets and service life assumptions. The life and economic
depreciation rates () are shown in Table 6. The depreciation rates are derived as 2/L,
where L is the life expectancy of an asset.
The corporate income tax rate (u t )
The traditional way of estimating this rate is to compute the ratio of total corporate profits
tax liability to before-tax total profits. The corporate tax is reported in our data set and the
before-tax total profit is calculated as total value-added less total costs.
The rate of indirect taxes (xt )
The effective rate of indirect taxes is assumed to be equal for all assets in all manufacturing
sector, defined as total indirect taxes divided by the total wealth stock.
Present value of $1 of tax depreciation allowances (z t )
This is the proportion of investment expenses that can be recovered in capital consumption
allowances after discounting these allowances for nominal interest charges. For simplicity,
all firms are assumed to select straight-line depreciation. Then, for a given discount rate, rt ,
which is the average long-term bond rate, and lifetime allowable for tax purposes, L (which
we chose in the preceding table), Christensen and Jorgensons (1969) formula is
zt =

L
1
1
1
.
rt L
1 + rt

Effective rate of the investment tax credit (et )

We use the nominal rate of the investment tax credit, 7%. The limitation of the nominal
rate is discussed by Christensen and Jorgenson (1969).

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Nominal rate of return on capital (rt )

From the BEA definition,
rt =

Yt K t qt xt K t (qt t qt + qt1 )(1 u t z t et )/(1 u t )

,
K t qt (1 u t z t et )/(1 u t )

where Yt is capital (property) income and K t is the capital stock. Capital income contains
profits, net interest, capital consumption allowances, transfers, indirect business taxes, and
inventory valuation adjustments. Because MPIT reports value-added (total revenue less
purchase) deduction of direct costs (labor) from this value added is an approximation of
capital income.
Acknowledgments
We are grateful to the guest editor Professor Michael J. Shaw and anonymous reviewers
for many helpful comments and suggestions. We have also benefited from valuable insights
provided by Professor Subal Kumbhakar, Department of Economics, The University of
Texas at Austin. We thank the Strategic Planning Institute, Boston, especially Donald
Swire, for providing access to the data used in this study. This research was supported in
part by grant No. IRI 9210398 from the National Science Foundation.
Notes
1. An SBU is defined as a unit of a firm selling a distinct set of product(s) or service(s) to an identifiable set
of customers in competition with a well-defined set of competitors and constitutes the unit of analysis in our
study.
2. That is, the real ratio of IT in 1987 constant dollars to that of fixed investments. The nominal ratio is calculated
based on current dollar values.
3. After 1982, this became the definition of the category Information Processing and Related Equipment (IPRE).
Since the change of definition involved only a regrouping of categories, throughout the paper we will use IPRE
as the definition of IT used in our study.
4. The Times Series Processor program allows the FIML estimation of a nonlinear simultaneous equations model.
This procedure requires the specification of a list of endogenous variables (TSP International, 1992).
5. Barua et al. (1995) provide a theoretical rationale to support the SBU as an appropriate level of analysis in
measuring IT impact.

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