Information Technology and the American Productivity Resurgence

By 
Dale W. Jorgenson
Samuel W. Morris University Professor
Harvard University

	The resurgence of the American economy since 1995 survived the dot-com crash of 2000, the short recession of 2001, and the “jobless” recovery that followed. The financial crisis resulting from the collapse of sub-prime mortgage lending has generated a strenuous debate: Can the improvements in America's economic performance be sustained? A consensus has emerged that the consummate science-based business of information technology (IT) provides a strong foundation for the future growth of the American economy.
The information technology mantra – faster, better, cheaper – characterizes the speed of technological change and product improvement in semiconductors, the key enabling technology. The economics of IT begins with the precipitous and continuing fall in semiconductor prices. The rapid price decline has been transmitted to the prices of a range of products that rely on this technology, like computers and telecommunications equipment. Semiconductor technology has also reduced the costs of aircraft, automobiles, scientific instruments, and a host of other products.
Swiftly falling IT prices have provided powerful economic incentives for the rapid diffusion of information technology through investment in IT hardware and software. A substantial acceleration in the IT price decline occurred in 1995, triggered by a much sharper acceleration in the price decline for semiconductors. The accelerated IT price decline after 1995 signaled even faster innovation in the main IT-producing industries - semiconductors, computers, communications equipment, and software. 
Productivity growth is the key economic indicator of innovation. Economic growth can take place without innovation through replication of established technologies. Investment increases the availability of these technologies, while the labor force expands as population grows. With only replication and without innovation, output will increase in proportion to capital and labor inputs. By contrast the successful introduction of new products and new or altered processes, organization structures, systems, and business models generates growth of output that exceeds the growth of capital and labor inputs. This results in growth in productivity or output per unit of input.
The industries responsible for much of IT hardware – computers and semiconductors – 
display truly extraordinary rates of productivity growth, as well as substantial accelerations after 1995. Together with telecommunications equipment and software, these IT-producing industries make up less than three percent of the U.S. economy, but generated almost all of the increase in economy-wide productivity growth in 1995-2000. The dot-com crash in 2000 resulted in a return to more sustainable productivity growth rates in the four IT-producing industries. 
Surprisingly, productivity growth in the U.S. economy has undergone another jump since the dot-com crash, indicating accelerating innovation. This has been accomplished by a striking shift in the locus of innovation to IT-using industries. These are the industries particularly intensive in the utilization of information technology hardware and software. The IT-users are primarily trade and service industries – communications services, business services, and wholesale trade – altogether more than a quarter of the U.S. economy. This is the core of the New Economy that is only gradually penetrating sectors traditionally resistant to innovation – health care, education, and government.
The flood of IT investment in the United States after 1995 has counterparts throughout the world. The burst of IT investment in industrialized economies after 1995 was unmistakable. The world economy has undergone a powerful growth resurgence and investment in IT is rising sharply in the major developing and transition economies – Brazil, China, India, and Russia. However, differences in the rates of innovation in the IT-using industries have generated wide disparities in the impact of IT on economic growth. Among the industrialized countries rates of innovation in the IT-using industries are greatest in the U.S.
Highly volatile IT production is giving way to a broadly diversified advance in IT applications. These applications now spawn innovation in almost a quarter of the U.S. economy, but well under half this proportion of the world economy. Globalization is creating enormous new opportunities for the science-based business of information technology. The source of international competitiveness in the New World Economy will be the successful exploitation of science-based business models, systems, and organizational structures – the subject of the Harvard Business School Centennial Colloquium on Science-Based Business. 
1. Faster, Better, Cheaper.
     	Modern information technology begins with the invention of the transistor, a semiconductor device that acts as an electrical switch and encodes information in binary form. A binary digit or bit takes the values zero and one, corresponding to the off and on positions of a switch. The first transistor, made of the semiconductor germanium, was constructed at Bell Labs in 1947 and won the Nobel Prize in Physics in 1956 for the inventors -- John Bardeen, Walter Brattain, and William Shockley.
The next major milestone in information technology was the co-invention of the integrated circuit by Jack Kilby of Texas Instruments in 1958 and Robert Noyce of Fairchild Semiconductor in 1959. An integrated circuit consists of many, even billions, of transistors that store and manipulate data in binary form. Integrated circuits were originally developed for data storage and retrieval and semiconductor storage devices became known as memory chips. 
The first patent for the integrated circuit was granted to Noyce. This resulted in a decade of litigation over the intellectual property rights. The litigation and its outcome demonstrate the critical importance of intellectual property in the development of information technology. Kilby was awarded the Nobel Prize in Physics in 2000 for discovery of the integrated circuit; regrettably, Noyce died in 1990.
In 1965 Gordon Moore, then Research Director at Fairchild Semiconductor, made a prescient observation, later known as Moore's Law. Plotting data on memory chips, he observed that each new chip contained roughly twice as many transistors as the previous chip and was released within 18-24 months of its predecessor. This implied exponential growth of chip capacity at 35-45 percent per year! Moore's prediction, made in the infancy of the semiconductor industry, has tracked chip capacity for more than forty years. He recently extrapolated this trend well into the future.
In 1968 Moore and Noyce founded Intel Corporation to speed the commercialization of memory chips. Integrated circuits gave rise to microprocessors with functions that can be programmed by software, known as logic chips. Intel's first general purpose microprocessor was developed for a calculator produced by Busicom, a Japanese firm. Intel retained the intellectual property rights and released the device commercially in 1971.
The rapidly rising trends in the capacity of microprocessors and storage devices illustrate the exponential growth predicted by Moore's Law. The first logic chip in 1971 had 2,300 transistors. In 2008 Intel plans to release the Tukwila microprocessor with more than two billion transistors. Over this thirty-seven year period the number of transistors on a chip will have increased by thirty-seven percent per year. The rate of productivity growth for the U.S. economy during this period was slower by two orders of magnitude.
2. Prices of Information Technology. 
     	Moore's Law captures the fact that successive generations of semiconductors are faster and better. The economics of semiconductors begins with Moore’s closely related observation that semiconductors have become cheaper at a truly staggering rate. Figure 1 gives semiconductor price indexes constructed by Bruce Grimm (1998) of the Bureau of Economic Analysis (BEA) and employed in the U.S. National Income and Product Accounts (NIPAs) since 1996. These are divided between memory chips and logic chips. 
Between 1974 and 1996 prices of memory chips decreased by a factor of 27,270 times or 40.9 percent per year, while the implicit deflator for the U.S. gross domestic product (GDP) increased by almost 2.7 times or 4.6 percent per year. Prices of logic chips, available for the shorter period 1985 to 1996, decreased by a factor of 1,938 or 54.1 percent per year, while the GDP deflator increased by 1.3 times or 2.6 percent per year. Semiconductor price declines closely parallel Moore's Law on chip capacity, setting semiconductors apart from other products.
Figure 1 also reveals a sharp acceleration in the decline of semiconductor prices in 1994 and 1995. The microprocessor price decline leapt to more than ninety percent per year as the semiconductor industry shifted from a three-year product cycle to a greatly accelerated two-year cycle. This is reflected in the 2005 Update of the International Technology Road Map for Semiconductors, prepared by a consortium of industry associations. However, the accelerated decline of semiconductor prices proved to be transitory and has reverted to more sustainable rates after the dot-com crash of 2000. 
The behavior of semiconductor prices is a severe test for the methods used in the official price statistics. The challenge is to decompose observed price declines between changes in semiconductor performance and declines in prices that hold performance constant. Achieving this objective has required a detailed understanding of the technology, the development of sophisticated measurement techniques, and the introduction of novel methods for assembling the requisite information. 
Ellen Dulberger (1993) of IBM introduced a "matched model" index for semiconductor prices. A matched model index combines price relatives for products with the same performance at different points of time. Grimm (1998) combined matched model techniques with hedonic methods, based on an econometric model of semiconductor prices at different points of time. A hedonic model gives the price of a semiconductor product as a function of the characteristics that determine performance, such as speed of processing and storage capacity. A constant quality price index isolates the price change by holding these characteristics of semiconductors fixed. 
The introduction of the Personal Computer (PC) by IBM in 1981 was a watershed event in the deployment of information technology. The sale of Intel's 8086-8088 microprocessor to IBM in 1978 for incorporation into the PC was a major business breakthrough for Intel. In 1981 IBM licensed the MS-DOS operating system from the Microsoft Corporation, founded by Bill Gates and Paul Allen in 1975. The PC established an Intel/Microsoft relationship that has continued up to the present. In 1985 Microsoft released the first version of Windows, its signature operating system for the PC, giving rise to the Wintel (Windows-Intel) nomenclature for this ongoing collaboration. 
Mainframe computers, as well as PC's, have come to rely heavily on logic chips for central processing and memory chips for main memory. However, semiconductors account for less than half of computer costs and computer prices have fallen much less rapidly than semiconductor prices. In 1985 the Bureau of Economic Analysis incorporated constant quality price indexes for computers and peripheral equipment constructed by IBM into the NIPAs. Dulberger (1989) presented a more detailed report on her research on the prices of computer processors for the BEA-IBM project. Speed of processing and main memory played central roles in her model. Triplett (2005) has provided an exhaustive survey of research on hedonic price indexes for computers. 
Figure 1 gives BEA's constant quality index of prices of computers and peripheral equipment and its components, including mainframes, PC's, storage devices, and other peripheral equipment. The decline in computer prices follows the behavior of semiconductor prices, but in much attenuated form. The 1995 acceleration in the computer price decline parallels the acceleration in the semiconductor price decline. Like the decline of semiconductor prices, this reverted to historical rates after the dot-com crash of 2000. 
Communications technology is crucial for the rapid development and diffusion of the Internet, perhaps the most striking manifestation of information technology in the American economy. Communications equipment is an important market for semiconductors, but constant quality price indexes cover only a portion of this equipment. Switching and terminal equipment rely heavily on semiconductor technology, so that product development reflects improvements in semiconductors.
Much communications investment takes the form of the transmission gear, connecting data, voice, and video terminals to switching equipment. Technologies such as fiber optics, microwave broadcasting, and communications satellites have progressed at rates that outrun even the dramatic pace of semiconductor development. An example is dense wavelength division multiplexing (DWDM), a technology that sends multiple signals over an optical fiber simultaneously. Installation of DWDM equipment, beginning in 1997, has doubled the transmission capacity of fiber optic cables every 6-12 months. 
Both software and hardware are essential for information technology and this is reflected in the large volume of software expenditures. The 1999 revision of the U.S. national accounts first classified software as investment. Before this business expenditures on software were treated as current outlays, while personal and government expenditures were treated as purchases of non-durable goods. Software investment is growing rapidly and is now much more important than investment in computer hardware.
The national accounts distinguish three types of software -- prepackaged, custom, and own-account software. Prepackaged software is sold or licensed in standardized form and is delivered in packages or electronic files downloaded from the Internet. Custom software is tailored to the specific application of the user and is delivered along with analysis, design, and programming services required for customization. Own-account software consists of software created for a specific application. Only price indexes for prepackaged software hold performance constant. 
3. Economic Impact of Information Technology.
We next consider the impact of information technology (IT) on economic growth. For this purpose the American growth resurgence after 1995 must be traced to sources within the individual industries. Output and productivity for the four information technology-producing (IT-producing) industries – semiconductors, computers, communications equipment, and software –must be separately identified. The remaining industries must be divided between the IT-using industries, those that are particularly intensive in the utilization of information technology equipment and software, and the Non-IT industries. 
Figure 2 presents the sources of growth of the U. S. gross domestic product (GDP), the most comprehensive measure of national output. For the period 1960-1995 the GDP grew at a little over three percent per year. More than half of this growth was due to investment in IT and Non-IT capital input, indicated in blue. Non-IT capital growth in light blue greatly predominated over IT growth in dark blue. 
The most distinctive features of IT assets are the rapid declines in prices of these assets, as well as relatively high rates of depreciation. The price of an asset is transformed into the price of the corresponding capital input by an annualization factor known as the cost of capital.  The cost of capital includes the nominal rate of return, the rate of depreciation, and the rate of capital loss due to declining prices. The distinctive characteristics of IT prices – high rates of price decline and rates of depreciation – imply that prices of IT capital inputs are very large by comparison with prices of IT capital assets. 
	The annualized prices of capital inputs are essential for assessing the contribution of investment in IT equipment and software to economic growth. This contribution is the relative share of IT equipment and software in the value of output, multiplied by the rate of growth of IT capital inputs. A substantial part of the contribution of capital input in 1960-1995 can be traced to the change in composition of investment associated with the growing importance of IT equipment and software. 
Labor input in red contributed about a third of U.S. economic growth during 1960-1995 and was the next most important source of U.S. economic growth. College-educated workers in dark red accounted for well over half of this, despite the fact that these workers make up only thirty percent of the labor force. The contribution of college-educated workers to economic growth is the relative share of these workers in the value of output, multiplied by the growth rate of their hours worked. Personnel with a college degree or higher level of education coincide closely with “knowledge workers” who deal with information. Of course, not every knowledge worker is college-educated and not every college graduate is a knowledge worker. The contribution of non-college workers to economic growth is indicated in light red.
The growth of productivity or output per unit of input is the key economic indicator of innovation. Although the role of innovation is often described as the predominant source of economic growth, the growth of productivity indicated in gold accounted for only a little over eleven percent of U.S. growth in 1960-1995. This was far less important than the contributions of capital and labor inputs and comparable in magnitude to the contribution of investment in IT equipment and software alone.  
The great bulk of growth is due to replication of established technologies. Innovation is obviously far more challenging and subject to much greater risk. The diffusion of successful innovation requires mammoth financial commitments. These fund the investments that replace outdated products and processes and establish new organization structures, systems, and business models. Although innovation accounts for a relatively minor portion of U.S. economic growth, this portion is vital for maintaining gains in the U.S. standard of living in the long run.
Turning to the sources of the U.S. growth acceleration after 1995, we find that the contribution of capital input was by far the most significant. Growth increased by almost a full percentage point in 1995-2000. The outpouring of IT investment in response to the sharp decline in IT prices after 1995 contributed almost three-quarters of this growth. Many industries substituted IT equipment and software for Non-IT investment, leading to a decline in the contribution of Non-IT investment to growth.  
The increased contribution of labor input in 1995-2000 was almost evenly divided between college and non-college workers, but the contribution of knowledge workers continued to predominate. Innovation also rose during the IT investment boom, accounting for just under thirteen percent of U.S. economic growth. Although the pace of innovation clearly accelerated, the contribution of productivity was comparable to that of non-college workers and well below IT investment. 
	The rapid pace of U.S. economic growth after 1995 was not sustainable. In 2000-2005 the overall growth rate dropped to just under three per cent per year, well below the long-term average of 1960-1995. The contribution of investment also declined below the 1960-1995 average, but the powerful shift from Non-IT to IT capital input continued. The contribution of labor input dropped precipitously, accounting for most of the decline in economic growth during the “jobless” recovery that followed the dot-com crash of 2000. The contribution to growth by knowledge workers continued at a reduced rate, but that of non-college workers was negative.
	The most remarkable feature of the recovery of 2000-2005 was a spectacular climb in productivity growth, indicating a renewed surge of innovation. Figure 3 decomposes productivity growth into the contributions of the four IT-producing industries, twenty-eight IT-using industries, and fifty-three Non-IT industries. The four IT-producing industries comprise about three percent of the GDP, the IT-using industries a little over a quarter, and Non-IT industries seventy-one percent. 
During 1960-1995 the IT-producing industries accounted for almost forty percent of innovation, far out of proportion to their three percent of the GDP. In the IT investment boom of 1995-2000 these industries accounted for more than sixty percent of the substantially increased contribution of innovation. After the dot-com crash the contribution of the IT-producing industries to innovation approached the long term average of 1960-1995. How, then, did innovation accelerate in 2000-2005? 
	Figure 3 shows a steady increase in rates of innovation in the Non-IT industries, making up more than seventy percent of the GDP. The rate of productivity growth in these industries nearly doubled after 1995 and increased by a slightly smaller proportion after 2000. The emergence of innovation in the IT-using industries, making up a little over a quarter of the economy, was the main source of the jump in productivity growth in 2000-2005. Innovation in these industries had been almost negligible from 1960-1995 and was actually negative in 1995-2000 as IT-using industries were nearly swamped by investments in IT equipment and software.
	Figure 4 provides a graphical representation of the radical shift in the locus of U.S. innovation after the dot-com crash. This depicts the difference in the contribution of productivity to U.S. economic growth between 2000-2005 and the thirty-five year period 1960-1995 for twenty-eight IT-using industries. Not all of these differences are positive; the total contribution of IT-producing industries to the overwhelming surge of innovation in the U.S. economy is concentrated in eight of the twenty-eight industries. Communications services, the industry providing the hardware and software support for the vast expansion of the Internet, heads the list. The remaining seven industries are in services and trade. 
	We have now laid bare the foundations of the New Economy that emerged from the dot-com crash and the recovery that followed. The IT-using industries were nearly inundated by the flood investment in IT equipment and software after 1995. These industries not only recovered, but replaced outmoded organization structures, systems, and business models with new services and new processes for delivering these services. For example, voice, data, and video communications moved onto the Internet as Broadband services become available to households along with mobile and landline communications services. 
	Insurance carriers, like banks before them, completed the transfer of their immense volume of transactions – sales, premiums, claims, and cash disbursements – onto the Internet, displacing face-to-face transactions, voice communications, and paper records. Airlines, long-time leaders in applications of IT equipment and software, adopted new business systems for electronic load management. Wholesale trade, including industry leaders like Wal-Mart and Cisco, integrated supply chains around the world, linking electronic cash registers at retail outlets and business-to-business ordering systems with order dispatch and transportation scheduling at remote factories. 
	The long reach of globalization is evident in Figure 5, showing the surge in IT investment in the world economy after 1995. The pattern of IT investment in dark blue in the G7 and Non-G7 industrialized economies mirrors that in the U.S. but on a substantially reduced scale. Beginning from much lower levels in 1989-1995, the contribution of IT investment in Developing Asia after 2000 is comparable to G7 levels. 
	The transformation of the U.S. economy by the new wave of innovation has counterparts, especially in the relatively small Scandinavian economies, Ireland, and Israel. However, Figure 6 shows that the acceleration of U.S. innovation has been accompanied by a marked deceleration in productivity growth in the four major economies of the European Union – France, Germany, Italy, and the U.K. – homes to many of the leading competitors for U.S. multi-nationals.  Applications of information technology have encountered formidable obstacles in many economies, due to deeply entrenched policies of market and job protection.	
	Unfortunately, policies of market and job protection are not limited to industrialized economies. Figure 7 shows the sources of economic growth for seven major developing and transition economies. The contribution of investment in information technology equipment and software has risen steadily in Brazil, China, India, Russia, and South Korea, while Indonesia and Mexico have been left behind. Brazil, Indonesia, and Mexico give little evidence of sustained innovation, while China and India are slowly catching up to other Asian economies. Russia is only now fully recovered from the economic collapse of the 1990’s and South Korea’s rate of productivity growth has declined since the Asian financial crisis.
4. The New World Economy.
	The production of information technology equipment and software has proved to be highly volatile; the great IT investment boom of 1995-2000 was followed by the dot-com crash and the slow and painful recovery of 2000-2005. The boom of 1995-2000 was generated by an unsustainable deluge of innovation in the production of semiconductors and semiconductor-intensive computer and telecommunications equipment. By contrast the wave of innovation that followed in 2000-2005 was spread across a much broader spectrum of trade and service industries. This has created a diversified advance in the applications of information technology in almost a quarter of the U.S. economy. 
	Successful applications of information technology require new organizational structures to manage the steady procession of new generations of equipment and software. These organizational structures themselves rapidly become antiquated, so that executive-level management of science-based businesses must direct a continuous process of restructuring. Business systems have become imbedded in software that requires incessant updating as business needs evolve. Business models for innovation are selected by the market in a process of “creative destruction” first described by Joseph A. Schumpeter nearly 100 years ago. 
	Globalization through trade in goods, especially manufactured goods and natural resource products like oil and gas, has steadily advanced with the opening of the major economies of China, India, and Russia. However, globalization of services is only beginning, accompanied by a chorus of populist attacks on “outsourcing” and “offshoring”. The European Union, founded on the principle of a single market, has utterly failed to create a single market in trade and services, which make up 70-80 percent of activity in most industrialized economies. A central feature of the U.S. economy now powering innovation is the gradual extension of a single market in trade and services through broadening the scope of application of the Interstate Commerce clause of the U.S. Constitution. 
The removal of impediments to applications of information technology is opening new business prospects on a daily basis, not only in industrialized economies, but in developing and transition economies like Brazil, China, India, and Russia. Some of these economies are already major participants in information technology production. However, the arena for competition has shifted to IT-using trade and service industries.  International competitiveness in the New World Economy will be rooted in the science-based business models, systems, and organizational structures that emerged phoenix-like from the ruins of the dot-com crash of 2000.