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

15 Pages Posted: 17 May 2002

See all articles by Kim B. Clark

Kim B. Clark

Harvard Business School; National Bureau of Economic Research (NBER); Brigham Young University Idaho

Carliss Y. Baldwin

Harvard Business School, Finance Unit

Date Written: May 2002

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.

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

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

Suggested Citation

Clark, Kim and Baldwin, Carliss Y., The Option Value of Modularity in Design: An Example From Design Rules, Volume 1: The Power of Modularity (May 2002). Harvard NOM Working Paper No. 02-13; Harvard Business School Working Paper No. 02-078. Available at SSRN: https://ssrn.com/abstract=312404 or http://dx.doi.org/10.2139/ssrn.312404

Kim Clark

Harvard Business School ( email )

Soldiers Field
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Boston, MA 02163
United States
617-495-6550 (Phone)
617-495-0316 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Brigham Young University Idaho

525 S Center St
Rexburg, ID 83440
United States

Carliss Y. Baldwin (Contact Author)

Harvard Business School, Finance Unit ( email )

Boston, MA 02163
United States

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