The Fundamental Theorem of Design Economics

Keywords

technological innovation, real options, information goods, design, modularity, experimentation, modular design evolution

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.

Original Publication Citation

"""The Fundamental Theorem of Design Economics"" (2002). Harvard Business School Working Paper, No. 02-077. (With C.Y. Baldwin)"

Document Type

Working Paper

Publication Date

2002

Publisher

Harvard Business School

Language

English

College

Marriott School of Business

Department

Marketing

University Standing at Time of Publication

Full Professor

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