ECONOMIC SYSTEMS ANALYSIS AND ASSESSMENT ffirs 14February2011;14:44:50 WILEY SERIES IN SYSTEMS ENGINEERING AND MANAGEMENT Andrew P. Sage, Editor A complete list of the titles in this series appears at the end of this volume. ffirs 14February2011;14:44:50 ECONOMIC SYSTEMS ANALYSIS AND ASSESSMENT Cost, Value, and Competition in Information and Knowledge Intensive Systems, Organizations, and Enterprises Andrew P. Sage DepartmentofSystemsEngineeringandOperationsResearch, GeorgeMasonUniversity, Fairfax,VA22030-4444 William B. Rouse TennenbaumInstitute SchoolofIndustrialandSystemsEngineering, CollegeofComputing, GeorgiaInstituteofTechnology, Atlanta,GA30332 JOHNWILEY&SONS,INC. ffirs 14February2011;14:44:50 Copyrightr2011byJohnWiley&Sons,Inc.Allrightsreserved. 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Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsinprint maynotbeavailableinelectronicformats.FormoreinformationaboutWileyproducts,visitour websiteatwww.wiley.com. LibraryofCongressCataloging-in-PublicationData: Sage,AndrewP. Economicsystemsanalysisandassessment/AndrewP.Sage,WilliamB.Rouse. p. cm.(cid:1) (Wileyseriesinsystemsengineeringandmanagement;54) ISBN978-0-470-13795-6(hardback) 1. Microeconomics. 2. Systemanalysis. I. Rouse,WilliamB. II. Title. HB172.S1272011 338.501—dc22 2010042299 PrintedinSingapore 10 9 8 7 6 5 4 3 2 1 ffirs 14February2011;14:44:50 CONTENTS PREFACE ix CHAPTER1 INTRODUCTIONTOECONOMICSYSTEMSANALYSISAND ASSESSMENT:COST,VALUE,ANDCOMPETITIONININFORMATION ANDKNOWLEDGEINTENSIVESYSTEMS,ORGANIZATIONS,AND ENTERPRISES 1 1.1. Introduction 1 1.2. AFrameworkforSystemsEngineeringandManagement 2 1.3. TheoryoftheFirm 14 1.4. TheoryoftheConsumer 17 1.5. TheInteractionoftheTheoriesofFirmsandConsumers:Microeconomic ModelsofEconomicActivity 18 1.6. WelfareorNormativeEconomics 26 1.7. ProgramandProjectManagementEconomics 29 1.8. ContemporaryIssuesConcerningInformationandInformationTechnology Economics 30 1.9. EconomicPitfallsintheEngineeringofSystems 35 1.10. Summary 41 CHAPTER2 PRODUCTIONANDTHETHEORYOFTHEFIRM 43 2.1. Introduction 43 2.2. TheProductionFunction 44 2.3. MultiproductFirmsandMultiproductProductionFunctions 61 2.4. ClassicTheoryoftheFirm 62 2.5. ImperfectCompetition 81 2.6. Summary 88 CHAPTER3 THETHEORYOFTHECONSUMER 95 3.1. Introduction 95 3.2. EconomicUtilityTheoryandItsAxioms 95 3.3. PropertiesofUtilityFunctions 100 3.4. TheFundamentalProblemoftheConsumer 102 3.5. SensitivityandSubstitutionEffects 120 3.6. Summary 130 v TOC 14February2011;14:45:53 vi CONTENTS CHAPTER4 SUPPLY(cid:1)DEMANDEQUILIBRIAANDMICROECONOMIC SYSTEMSANALYSISANDASSESSMENTMODELS 137 4.1. Introduction 137 4.2. BasicSupply(cid:1)DemandEquilibriumforaSingleGood 139 4.3. GeneralSupply(cid:1)DemandEquilibriumConditions 170 4.4. ExtensionstoGeneralEquilibriumtoIncludeMarketInterdependencies 184 4.5. MicroeconomicModels 196 4.6. Summary 198 CHAPTER5 NORMATIVEORWELFAREECONOMICS,DECISIONS ANDGAMES,ANDBEHAVIORALECONOMICS 205 5.1. Introduction 205 5.2. ParetoOptimalityunderPerfectCompetitionConditions 206 5.3. ExternalEffectsandImperfectCompetition:PublicGoods 218 5.4. ExternalEffectsandImperfectCompetition:NonindependentProductionand Consumption 229 5.5. WelfareMaximizationandSocialChoice 238 5.6. Summary 241 CHAPTER6 COST(cid:1)BENEFITANDCOST(cid:1)EFFECTIVENESSANALYSES ANDASSESSMENTS 251 6.1. Introduction 251 6.2. TheTimeValueofMoney 253 6.3. IdentificationofCostsandBenefits 274 6.4. TheIdentificationandQuantificationofEffectiveness 283 6.5. Summary 289 CHAPTER7 COSTASSESSMENT 297 7.1. Model-BasedParametersforProductivity 301 7.2. EarlyModelsforEstimationofCosts,IncludingEffortandSchedule 303 7.3. TheConstructiveCostModel 310 7.4. Summary 337 CHAPTER8 APPROACHESTOINVESTMENTVALUATION 343 8.1. Microeconomics 344 8.2. TheInvestmentProblem 348 8.3. InvestmentValuation 350 8.4. Summary 359 CHAPTER9 REALOPTIONSFORINVESTMENTVALUATION 361 9.1. NatureofOptions 361 9.2. OptionPricingTheory 364 9.3. OptionCalculator 367 9.4. StrategicMetrics 372 9.5. InvestmentDecisionMaking 374 TOC 14February2011;14:45:53 CONTENTS vii 9.6. Value-CenteredR&D 378 9.7. Summary 379 CHAPTER10 CONTEMPORARYPERSPECTIVES 383 10.1. Introduction 383 10.2. EvolutionaryEconomics 383 10.3. PathDependenceandNetworkEffects 384 10.4. IntellectualCapital 385 10.5. ValueofInformation 387 10.6. InvestinginHumans 388 10.7. Summary 390 INDEX 393 TOC 14February2011;14:45:53 PREFACE The purpose of this book is to provide a background in the fundamentals of economicsystemsanalysisandassessmentthatisappropriateforengineersand managersconcernedwiththesystemsengineeringandmanagementofsystems that are generally information technology intensive. It isassumed that readers of this book will have previously studied mathematics through calculus and differential equations, and that they have some background in linear algebra. Nopriorbackgroundinmathematicalprogrammingoreconomicsisassumed, although a modest exposure to undergraduate microeconomics will be very helpful. The objectives of this book include a salient discussion of engineering economic systems that will be relevant for those who need or desire to use the subject matter intheir professional practice.Thisbook willalso supportthose whomustcommunicateandbrokertheresultsofengineeringeconomicsystems analyses and assessments between the many professionals having a stake in definition, development, and deployment of information technology intensive systems. Finally, this book provides a thorough grounding in investment analysis and assessment, particularly for technology portfolios, capacity improvementandexpansion,andmergersandacquisitionstoacquiretechnol- ogies and/or capacity. The book itself is comprised of five major parts as follows: 1. Microeconomics. We provide a concise overview of classic microeco- nomicsincludingproduction and thetheory ofthefirm;theoryofthe consumer;marketequilibriaandmarketimperfections;andnormative or welfare economics, including imperfect competition effects and consumerandproducersurplus.Chapters2to5containthispresenta- tion. We also discuss some behavioral economics issues in this part, particularly in Chapter 5. These chapters are as follows: (cid:1) Chapter 1: Introduction to Economic Systems Analysis and Assessment (cid:1) Chapter 2: Production and the Theory of the Firm (cid:1) Chapter 3: The Theory of the Consumer (cid:1) Chapter 4: Supply(cid:3)Demand Equilibria and Microeconomic Sys- tems Analysis and Assessment Models (cid:1) Chapter5:NormativeorWelfareEconomics,DecisionsandGames, and Behavioral Economics 2. Program Management Economics. We discuss economic valuation of programs and projects including investment rates of return, ix fpref 14February2011;14:45:23 x PREFACE cost(cid:3)benefit and cost(cid:3)effectiveness analysis, earned value manage- ment, cost structures and estimation of program costs and schedules, strategic and tactical pricing issues, and capital investment and options. There is one lengthy chapter in this part: (cid:1) Chapter 6: Cost(cid:3)Benefit and Cost(cid:3)Effectiveness Analyses and Assessments 3. CostEstimation.Costestimationtechnologiesinvolveprecedentedand unprecedented development, commercial off-the-shelf (COTS) soft- ware, software reuse, application generators, and fourth-generation languages. Contemporary cost estimation methods are evaluated in terms of openness of underlying models, platform requirements, data required as inputs, output, and accuracy of estimates provided by the models. COCOMO I and II, and COSYSMO are examples of a cost model, function point cost estimation models. Cost is estimated for systems of systems engineering. There is a single chapter in this part: (cid:1) Chapter 7: Cost Assessment 4. Strategic Investments in an Uncertain World. The final part of our economic systems analysis and assessment efforts is concerned with valuation of major investments such as technology portfolios and large-scale capacity expansions, as well as mergers and acquisitions. Here we provide a chapter that addresses alternative methods for valuation of firms including Stern(cid:3)Stewart’s EVA, Holt’s CFROI, and various competing methodologies. Chapter 9 considers option- based valuation models including classic real option models (Black(cid:3) Scholes) and extensions for multistage options with more robust portfolio assumptions. Valuation of information technology intensive enterprisesisalsoaddressed.Overall,thispartprovidesadiscussionof valuationmethodsformanagingstrategicinvestmentsinanuncertain world: (cid:1) Chapter 8: Approaches to Investment Valuation (cid:1) Chapter 9: Real Options for Investment Valuation 5. Extensions to the Work. There are many extensions possible to economic systems analysis and assessment. There are needed exten- sions to the classic microeconomics of economic systems analysis and assessmenttoenablesatisfactorytreatmentoftheincreasingreturnsto scale, network effects, and path-dependent issues generally associated withcontemporaryultra-large-scaletelecommunicationsandinforma- tion networks. Investing in the training and education, safety and health, and work productivity of humans is another very important issue. In our concluding chapter of this work, we present a very brief discussion of these issues: (cid:1) Chapter 10: Contemporary Perspectives fpref 14February2011;14:45:23 PREFACE xi We sincerely hope that readers find our discussions of economic systems analysis and assessment of value to their work in systems and software engineering, systems and enterprise management, and related areas. Andrew P. Sage Department of Systems Engineering and Operations Research George Mason University Fairfax, VA 22030-4444 William B. Rouse Tennenbaum Institute School of Industrial and Systems Engineering College of Computing Georgia Institute of Technology Atlanta, GA 30332 fpref 14February2011;14:45:23