1. Slide 1 © Carliss Y. Baldwin and Kim B. Clark, 2005 Unmanageable Designs: What Some Designs Need from the Economy and How They Get It Carliss Y. Baldwin Harvard Business School 2005 SDM Conference October 27, 2005

2. Slide 2 © Carliss Y. Baldwin and Kim B. Clark, 2005 Three Points  Designs “need” to become real –They become real by creating the perception of “value”  Designs act as a financial force –Perception of value = Incentive to invest –In making the design— “use value” –In making the design better— “option value”  Modular Designs with Option Potential –Create hurricane-type forces –Will change their economic “space” –Unmanageable and dangerous (unless you understand them)

3. Slide 3 © Carliss Y. Baldwin and Kim B. Clark, 2005 Metaphor— “Selfish Designs”  “Selfish” designs want to become real  Their tool is human motivation –A user perceives use-value => willingness to make or willingness-to-pay –Designers and producers estimate willingness to pay –The result is an asset => financial value  Humans move mountains for financial value –Value operates “as a force” in the economy –Some designs have so much of this force that we work for them…

4. Slide 4 © Carliss Y. Baldwin and Kim B. Clark, 2005 Strong value forces can change the shape of an industry  Andy Grove described a vertical-to-horizontal transition in the computer industry: “Modular Cluster” “Vertical Silos”

5. Slide 5 © Carliss Y. Baldwin and Kim B. Clark, 2005 Andy’s Movie Stack View in 1980 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

6. Slide 6 © Carliss Y. Baldwin and Kim B. Clark, 2005 Andy’s Movie Stack View in 1995 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

7. Slide 7 © Carliss Y. Baldwin and Kim B. Clark, 2005 Andy’s Movie—the Sequel Stack View in 2002 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

8. Slide 8 © Carliss Y. Baldwin and Kim B. Clark, 2005 Turbulence in the Stack Departures from Top 10:  Xerox (~ bankrupt)  DEC (bought)  Sperry (bought)  Unisys (marginal)  AMP (bought)  Computervision (LBO) Arrivals to Top 10:  Microsoft  Cisco  Oracle  Dell  ADP  First Data Sic Transit Gloria Mundi… Sic Transit

9. Slide 9 © Carliss Y. Baldwin and Kim B. Clark, 2005 Value Migration: 1950-1996 Significant Option- Rich Modular Design Architectures IBM System/360 DEC PDP 11; VAX IBM PC Sun 2; 3; Java VM RISC Internet Protocols (end-to-end principle) Unix and C; Linux HTML; XML(?)

10. Slide 10 © Carliss Y. Baldwin and Kim B. Clark, 2005 This was the puzzle Kim Clark and I began to tackle in 1987 Where was the value shown in the slide coming from? Designs, yes, but what part and why?

11. Slide 11 © Carliss Y. Baldwin and Kim B. Clark, 2005 After studying the designs and correlating their changes with value changes We concluded that modularity was part of the answer…

12. Slide 12 © Carliss Y. Baldwin and Kim B. Clark, 2005 IBM System/360  First modular computer design architecture (1962-1967) –Proof of concept in hardware and application software –Proof of option value in market response and product line evolution –System software was NOT modularizable »Fred Brooks, “The Mythical Man Month” »Limits of modularity

13. Slide 13 © Carliss Y. Baldwin and Kim B. Clark, 2005 1965—IBM wanted to be the sole source of all of System/360’s Modules

14. Slide 14 © Carliss Y. Baldwin and Kim B. Clark, 2005 IBM System/360  IBM did not understand the option value it had created  Did not increase its inhouse product R&D  Result: Many engineers left –to join “plug-compatible peripheral” companies  San Jose labs —> Silicon Valley “Compelling, surprising, dangerous”

15. Slide 15 © Carliss Y. Baldwin and Kim B. Clark, 2005 1975— What actually happened: Entry on modules

16. Slide 16 © Carliss Y. Baldwin and Kim B. Clark, 2005 By 1980, 100s of firms made S/360 “plug-compatible” components

17. Slide 17 © Carliss Y. Baldwin and Kim B. Clark, 2005 Short History (continued)  Bell and Newell, Computer Structures (1971) –General principles of modular design for hardware –Basis of PDP-11 design—another ORMDA  Thompson and Ritchie, Unix and C (1971-1973) –Modular design of operating system software (contra Brooks Law) –Over time, general principles for evolvable software design (Unix philosophy)  Mead and Conway, Intro to VLSI Systems (1980) –Principles of modular design for large-scale chips

18. Slide 18 © Carliss Y. Baldwin and Kim B. Clark, 2005 Short History (continued)  IBM PC (1983) –DEC PDP-11 minimalist strategy (exclude and invite) –+ Intel 8088 chip –+ DOS system software –+ IBM manufacturing –+ Lotus 1-2-3 –A modular design architecture with a mass market Visions of $$$ dance in your heads!

19. Slide 19 © Carliss Y. Baldwin and Kim B. Clark, 2005 As scientists, we can visualize and measure modularity in design — after the fact DSMs, Design Hierarchies Methods are tedious, non-automated

20. Mozilla just after becoming open source Linux of similar size Coord. Cost = 30,537,703 Change Cost = 17.35% Coord. Cost = 15,814,993 Change Cost = 6.65% Comparison of different software systems with DSM tools

21. Mozilla just after becoming open source Linux of similar size Coord. Cost = 30,537,703 Change Cost = 17.35% Coord. Cost = 15,814,993 Change Cost = 6.65% Conway’s Law: Different organizations deliver different architectures One Firm, Tight-knit Team, RAD methods Distributed Open Source Development

22. Mozilla Before Redesign Mozilla After Redesign !!

23. Slide 23 © Carliss Y. Baldwin and Kim B. Clark, 2005 But modularity is only half the story—options matter, too  “Creates” vs. “Frees up”  Designs have “option potential”, denoted    varies by system and by module Modularity in the absence of option potential is at best breakeven, at worst an expensive waste of time

24. Slide 24 © Carliss Y. Baldwin and Kim B. Clark, 2005 Modularity without (enough) option potential  Auto front-end modules (Fourcade) –Much experimentation, leading nowhere  Mobile computers (Whitney-Weinstein) –Power management favors more integral designs  Semiconductors (Strojwas) –IDMs vs. Fabless-Foundry pairs –Competing types of option potential –Both forms seem viable for now

25. Slide 25 © Carliss Y. Baldwin and Kim B. Clark, 2005 Stack View of the Semiconductor Industry (Strojwas, 2005) Top 10 Firms: 1994 and 2004

26. Slide 26 © Carliss Y. Baldwin and Kim B. Clark, 2005 What is this elusive property that gives rise to option value? Where does it arise? Can we measure it?

27. Slide 27 © Carliss Y. Baldwin and Kim B. Clark, 2005  Low Medium Zero High Measuring Option Potential  Successive, improving versions are evidence of option potential being realized over time—after the fact  Designers see option potential before the fact  What do they see?

28. Slide 28 © Carliss Y. Baldwin and Kim B. Clark, 2005 Major challenge in research and practice right now Science may not be able to deliver tools to measure ex ante option potential reliably But ex ante estimates are what’s needed

29. Slide 29 © Carliss Y. Baldwin and Kim B. Clark, 2005 Sources of option value 1  Physics— –Whitney: VLSI is different, more splittable –But there is also Moore’s Law »Dynamics of miniaturization »Virtuous cycle in mfr. cost and power consumption as chips get smaller »Explained by Mead and Conway in 1980 –Option value lies in seamless, asynchronous upgrading »Modeled in Design Rules

30. Slide 30 © Carliss Y. Baldwin and Kim B. Clark, 2005 Sources of option value 2  Users—new perceptions => new preferences –Perceptions of desires emerge through use –Value of discovery, direct experience, play –Unexplored preferences = option potential  Kim Clark (1985): Evolving design hierarchies create new preferences w.r.t. each module  Case studies of vertical disintegration driven by search/discovery of new preferences –Frozen food in the UK –Mortgage banking in the US (IO vs. PO)

31. Slide 31 © Carliss Y. Baldwin and Kim B. Clark, 2005 Sources of option value 3

32. Slide 32 © Carliss Y. Baldwin and Kim B. Clark, 2005 Sources of option value 3  Pfister’s Observation (in my language) –Recombining modules in new ways has more option value than the modules themselves  Amdahl’s Law “Make the frequent case fast”— –First architecture is not the best –Fred Brooks: “Build one and throw it away” –Value of architectural experimentation/optimization present in all complex systems  Not what we model in Design Rules –Architecture should be a (process) module –Stage in the value chain, node in the network

33. Slide 33 © Carliss Y. Baldwin and Kim B. Clark, 2005 Where we are in the argument:  Designs “need” to become real –They become real by creating the perception of “value”  Designs act as a financial force –Perception of value = Incentive to invest –Use value –Option value = Potential to improve  Modular Designs with Option Potential –Create hurricane-type forces –Will change their economic “space” –Unmanageable and dangerous (unless you understand them)

34. Slide 34 © Carliss Y. Baldwin and Kim B. Clark, 2005 Next questions  What do option-rich modular designs do to the economy?  How do you manage something inherently unmanageable?  Will you always get a modular cluster of firms?

35. Slide 35 © Carliss Y. Baldwin and Kim B. Clark, 2005 QUICK Answers  What do option-rich modular designs do in the economy? –Attract entry with a promise of lots of $$$  How do you manage something inherently unmanageable? –At first, you don’t –Then, small footprints yield high ROIC –Then, lead firm M&A  Will you always get a modular cluster of firms? –Yes, almost certainly

36. Slide 36 © Carliss Y. Baldwin and Kim B. Clark, 2005 Faced with this value proposition, what should you do? One module or many? In each module you chose, how many design searches? Which modules are most attractive?

37. Slide 37 © Carliss Y. Baldwin and Kim B. Clark, 2005 Lots of stories  They all make sense  When you see them play out, the moves are logical and in some cases “inevitable”  But our strategic advice for managers and financiers today comes down to: –“plunge in,” –“get lucky,” –“watch out for Microsoft,” and –“get bought by HP”

38. Slide 38 © Carliss Y. Baldwin and Kim B. Clark, 2005 Our research strategy—Look for  Stable patterns of behavior involving several actors operating within a consistent framework of ex ante incentives and ex post rewards  ==> Equilibria of linked games with self- confirming beliefs (Game theory)

39. Slide 39 © Carliss Y. Baldwin and Kim B. Clark, 2005 How a “stable pattern” works  Anticipation of $$$ (visions of IPOs)  Lots of investment  Lots of design searches  Best designs “win”  Fast design evolution => innovation  Lots of real $$$ (an actual IPO) “Rational expectations equilibrium”

40. Slide 40 © Carliss Y. Baldwin and Kim B. Clark, 2005 Three Stable Patterns (not quite Equilibria…)  “Blind” Competition –PCs in the early 1980s  High ROIC on a Small Footprint –Sun vs. Apollo –Dell vs. Compaq (and HP and …)  Lead Firm Competition –Monopoly—MSFT –Mergers & Acquisitions—Cisco, Intel …

41. “Blind” Competition

42. Slide 42 © Carliss Y. Baldwin and Kim B. Clark, 2005 Footprint Competion 1980— IBM provided few PC Modules

43. Slide 43 © Carliss Y. Baldwin and Kim B. Clark, 2005 But then …  Compaq reverse engineered the BIOS  Chips and Technologies made “chipsets”  Taiwanese clones had cheaper/better manufacturing  Intel refused to second-source 80386  Microsoft sabotaged OS/2

44. Slide 44 © Carliss Y. Baldwin and Kim B. Clark, 2005 1990—IBM PC is the standard, but IBM makes no money

45. Slide 45 © Carliss Y. Baldwin and Kim B. Clark, 2005 Footprint Competition—Apollo Keeps Design Control

46. Slide 46 © Carliss Y. Baldwin and Kim B. Clark, 2005 Then Sun came along… And did even less! How?

47. Slide 47 © Carliss Y. Baldwin and Kim B. Clark, 2005 Then Sun came along… And did even less! Design Architecture for performance Public Standards for outsourcing

48. Slide 48 © Carliss Y. Baldwin and Kim B. Clark, 2005 Result: ROIC advantage to Sun Sun used its ROIC advantage to drive Apollo out of the market

49. Slide 49 © Carliss Y. Baldwin and Kim B. Clark, 2005 Compaq vs. Dell  Dell did to Compaq what Sun did to Apollo …  Dell created an equally good machine, and  Used modularity-in-production to reduce its footprint in production, logistics and distribution costs –Negative Net Working Capital –Direct sales, no dealers  Result = Higher ROIC

50. Slide 50 © Carliss Y. Baldwin and Kim B. Clark, 2005 Higher ROIC always wins! Dell started cutting prices; Compaq struggled, but in the end had to exit. Like Apollo, they were acquired by HP!

51. Slide 51 © Carliss Y. Baldwin and Kim B. Clark, 2005 Lead Firms vs. Others  “Blind” competitors –don’t know others exist  “Footprint” competitors –Don’t expect to influence others—just compete  “Lead firms” –Must influence the beliefs of their competitors –FUD — “Fear, uncertainty and doubt” –Others cannot be blind!

52. Slide 52 © Carliss Y. Baldwin and Kim B. Clark, 2005 Monopoly or M&A?  Monopoly needs to deter all potential entrants with threats of price war –Very fragile equilibrium –Potentially expensive to create “enough” FUD  M&A Lead Firm does not try to deter all entry in the design space –Expects to buy most successful entrants ex post –More robust equilibrium –Maybe more advantageous, when you count the cost of FUD

53. Slide 53 © Carliss Y. Baldwin and Kim B. Clark, 2005 Industry Outcomes  “Blind” competition –Cluster (entry everywhere in the architecture)  “Footprint” competition –Cluster (small footprint => vertical disintegration)  M&A Lead Firm –Cluster (lead firm does not deter all entry)  Monopoly –One Big Firm

54. Slide 54 © Carliss Y. Baldwin and Kim B. Clark, 2005 Designs as an object of economic analysis—Remember  Designs “need” to become real –They become real by creating the perception of “value”  Designs act as a financial force –Perception of value = Incentive to invest  Modular Designs with Option Potential –Create hurricane-type forces –Will change their economic “space” –Unmanageable—cannot be confined in one firm or a supply chain –Dangerous (unless you understand them)

55. Slide 55 © Carliss Y. Baldwin and Kim B. Clark, 2005 One more story before we close— Significant Option- Rich Modular Design Architectures IBM System/360 DEC PDP 11; VAX IBM PC Sun 2; 3; Java VM RISC Internet Protocols (end-to-end principle) Unix and C; Linux HTML; XML(?)

56. Slide 56 © Carliss Y. Baldwin and Kim B. Clark, 2005 The Bright Side of the Option-rich Modular Designs

57. Slide 57 © Carliss Y. Baldwin and Kim B. Clark, 2005 But there was The Dark Side … $ 2.5 trillion appeared then disappeared in the space of four years!

58. Slide 58 © Carliss Y. Baldwin and Kim B. Clark, 2005 Bubble followed by a Crash A failure, not of the Internet’s design architecture, but of the economic institutions built on that architecture

59. Slide 59 © Carliss Y. Baldwin and Kim B. Clark, 2005 Ultimate unmanageability

60. Slide 60 © Carliss Y. Baldwin and Kim B. Clark, 2005 A reason—if we need one—to try to turn our stories into science…

61. Slide 61 © Carliss Y. Baldwin and Kim B. Clark, 2005 Thank you!