The Fundamental Theorem of Design Economics

9 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

Date Written: May 2002

Abstract

Every artifact has a design, and thus designs are an important class of information goods. In this paper, we establish the scope of the design valuation methodology based on real options, which we developed in Design Rules, Volume 1, The Power of Modularity (MIT Press, 2000). We argue that if an economic process is:

1. ex ante uncertain;

2. ex post rankable by outcome;

3. ex post contingent;

4. costly; and

5. has non-exclusive outputs;

and if better outcomes have higher financial value (are worth more money), then the value of that process will embed either simple real options (if the process is indivisible) or compound real options (if the process is modular). The real options, in turn, will have a "Q(k)-type structure," where Q(k) represents the expectation of the maximum of the outcomes of k processes run in parallel. We note that Q(k) is both an order statistic function and a real option function.

All design processes are ex ante uncertain; costly; and have non-exclusive outputs. Virtually all designs are ex post rankable by outcome within an appropriate functional category. Finally, many designs can be made ex post contingent by separating the design process from the production process for the artifact in question. Hence the fundamental theorem applies to a large subset of an important class of information goods.

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

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

Suggested Citation

Clark, Kim and Baldwin, Carliss Y., The Fundamental Theorem of Design Economics (May 2002). Harvard NOM Working Paper No. 02-12; Harvard Business School Working Paper No. 02-077, Available at SSRN: https://ssrn.com/abstract=312419 or http://dx.doi.org/10.2139/ssrn.312419

Kim Clark

Harvard Business School ( email )

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Brigham Young University Idaho

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Carliss Y. Baldwin (Contact Author)

Harvard Business School ( email )

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United States

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