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An abundance of flawed software has been identified as the main cause of the poor security of computer networks because major viruses and worms exploit the vulnerabilities of such software. As an incentive mechanism for software security quality improvement, software liability has been intensely discussed among both academics and practitioners for a long time. An alternative approach to managing software security is patch release, which has been widely adopted in practice. In this paper, we examine these two different ways of mitigating customer risk in the software market: liability and patch release. We study the impact of both mechanisms on a monopolistic software vendor's decision on security quality. We find the conditions under which each mechanism is effective in terms of improving security quality and increasing social surplus. The heterogeneous nature of loss is identified to be a key factor for the effectiveness of the liability mechanism. On the other hand, patch release can be effective and welfare‐enhancing regardless of the nature of loss as long as customers incur low patching cost, and/or the vendor incurs low patch development cost. We also examine the impact of customer misperception of the outcome from vulnerable software on the effectiveness of liability.

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A prime example of an emerging two-sided market is the driverless vehicle industry, an industry that will get much of its software from one side of the market: specifically, application developers. Consumers stand at the other side of this market. To what extent will this marketplace reward both the industry itself and application developers for technological innovation? In modeling this first question and keeping in mind consumers’ appetite for technological advances, we provide nuanced answers for executives in the driverless industry, application development firms, and government. This question speaks directly to what level of investment is optimal. Given that high government officials want to encourage the future growth of this vibrant industry, a second key theme of the paper is as follows. Should governments subsidize the focal industry or developers based on the extent to which they are innovative? Or should governments subsidize consumers? Our models conclude that subsidizing the industry is the overall best strategy followed by subsidies for consumers under certain other conditions. We find that it is not in the interest of society to subsidize application developers. Executives can use our models and results to fine tune to match their own circumstances with basic changes in our parameters.

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