The Option Value of Modularity in Design

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 σ, 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. THE OPTION VALUE OF MODULARITY IN DESIGN MAY 16, 2002 3 1 An Overview of the Research We are seeking to develop a technological theory of modularity and design evolution that can inform economic theories of industry evolution. Using the computer industry as a defining example, our book, Design Rules, explains: • what modularity is and how it can be attained; • how modularity makes it possible for designs to evolve in a localized fashion (modular design evolution); • how economic incentives operating at many points in a modular design eventually may lead to the emergence of a “modular cluster” of autonomous firms; • how modular designs create economic conflicts whose resolution may require new institutions regulating finance, employment and intellectual property within the cluster. The best way to motivate the study of modularity is to show the effect it can have on the structure of an industry. We collected data on the market values of substantially all the public corporations in the computer industry from 1950 to 1996, broken out into sixteen subsectors (see Figure 1). The data tell a story of industry evolution that runs counter to conventional wisdom. The dominant theories of industry evolution describe a process of pre-emptive investment by large, well-capitalized firms, leading to stable market structures and high levels of concentration over long periods of time. Figure 1 shows that there was indeed a period in which the computer industry was highly concentrated, with IBM playing the role of dominant firm. (IBM’s market value is the blue “mountain range” that forms the backdrop of the chart.) But in the 1980s, the computer industry “got away” from IBM. In 1969, 71% of the market value of the computer industry was tied up in IBM stock; by 1996, no firm accounted for more than 15% of the total value of the industry. 1 The arguments and all figures in this paper are taken from C.Y. Baldwin and K.B. Clark, Design Rules, Volume 1: The Power of Modularity, © MIT Press, 2000, reprinted by permission. Volume 2 is in progress. 2 The original theory of pre-emptive investment leading to industry concentration, with supporting historical evidence, was put forward by Alfred Chandler (1962, 1977). A complementary theory of concentration following the emergence of a “dominant design” was put forward by William Abernathy and James Utterback (1978). Modern formulations of these theories and some large-scale empirical tests have been developed by John Sutton(1992) and Steven Klepper (1996). Oliver Williamson (1985, Ch. 11) has interpreted the structures of modern corporations (unified and multi-divisional) as responses to potential opportunism (the hazards of market contracting). It is our position that the basic “task structures” and the economic incentives of modular design (and production) systems are different from the task structures and incentives of classic large-volume, high-flow-through production and distribution systems. Therefore the organizational forms that arise to coordinate modular design (and production) may not ressemble the classic structures of the modern corporation. THE OPTION VALUE OF MODULARITY IN DESIGN MAY 16, 2002 4 Figure 1 The Market Value of the Computer Industry By sector, 1950-1996 in constant 1996 US dollars 50 55 60 65 70 75 80 85 90 95 0 20 40 60 80 100 120 140 160 180 Year SIC Code or Company Source: Baldwin and Clark, 2000, Plate 1-1. By 1996, the computer industry consisted of a large modular cluster of over 1000 firms, no one of which was very large relative to the whole. The total market value of the industry, which increased dramatically through the 1980s and 1990s, was dispersed across the sixteen subindustries. Finally, the connections among products in the subindustries were (and are) quite complicated. Most computer firms did not design and make whole computer systems. Instead they designed or made modules that were parts of larger systems. In Design Rules, Volume 1: The Power of Modularity, we argue that a fundamental modularity in computer designs caused the industry to evolve from its initial concentrated structure to a highly dispersed structure. Modularity allows design tasks to be divided among groups that can work independently, and do not have to be parts of the same firm. Compatibility among modules is ensured by “design rules”, which govern the architecture and interfaces of the THE OPTION VALUE OF MODULARITY IN DESIGN MAY 16, 2002 5 system. The design rules must be adhered to by all, and hence can be a source of economic power to the firms that control them. Our theory of modular design and design evolution can be summarized as follows: • Modularity creates options; • Modular designs evolve as the options are pursued and exercised. We explain and amplify these points below. 2 Modularity creates options. 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. In general, modularizations serve three purposes, any of which may justify an investment in modularity: • Modularity makes complexity manageable; • Modularity enables parallel work; and • Modularity is tolerant of uncertainty. In this context, “tolerant of uncertainty” means that particular elements of a modular design may be changed after the fact and in unforeseen ways as long as the design rules are obeyed. Thus, 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.” Figure 2 portrays how the option structure of a system changes as it goes from an interdependent to a modular design structure. 3 A “modular design structure” is a particular structure of interdependencies among design or process parameters or, equivalently, tasks. The actual structure of any design or process or any set of tasks can be determined using the “Design Structure Matrix” mapping tools developed by Donald Steward (1981) and Steven Eppinger (1991). For numerous applications of this methodology, see http://web.mit.edu/dsm/publications_name.htm. THE OPTION VALUE OF MODULARITY IN DESIGN MAY 16, 2002 6 Figure 2 Modularity Creates Options System Before Modularization System after Modularization System Design Option Rules Option Option