The Option Value of Modularity in Design: An Example from Design Rules, Volume 1: The Power of Modularity

Abstract:     
When the design of an artifact is "modularized," the elements of the design are split up and assigned to modules according to a formal architecture or plan. Some of the modules are "hidden," meaning that design decisions in those modules do not affect decisions in other modules; some of the modules are "visible," meaning that they embody "design rules" that hidden-module designers must obey if the modules are to work together.

Modular designs offer alternatives that non-modular ("interdependent") designs do not provide. Specifically, in the hidden modules, designers may replace early, inferior solutions with later, superior solutions. Such alternatives can be modeled as "real options." In Design Rules, Volume 1: The Power of Modularity (MIT Press, 2000) we sought to categorize the major options implicit in a modular design, and to explain how each type can be valued in accordance with modern finance theory. This paper provides an example of the valuation of the modular options "splitting" and "substitution."

We show that the key drivers of the "net option value" of a particular module are (1) its "technical potential" (labeled s, because it operates like volatility in financial option theory); (2) the cost of mounting independent design experiments; and (3) the "visibility" of the module in question. The option value of a system of modules in turn can be approximated by adding up the net option values inherent in each module and subtracting the cost of creating the modular architecture. A positive value in this calculation justifies investment in a new modular architecture.

Number of Pages in PDF File: 15

Keywords: Technological Innovation, Real Options, Information Goods, Design, Modularity, Experimentation, Modular Design Evolution, Industry Evolution

JEL Classification: D83, G31, G34, L22, L23, O31, O34

working papers series