This paper develops a theory of sequential investments in cybersecurity in which the software vendor can invest ex ante and ex post. The regulator can use safety standards and liability rules as means of increasing security. A standard is a minimum level of safety, and a liability rule states the amount of damage each party is liable for. I show that the joint use of an optimal standard and a full liability rule leads to underinvestment ex ante and overinvestment ex post because the software vendor does not suffer the full costs of the society in case of security failure. Instead, switching to a partial liability rule can correct the inefficiencies. This suggests that to improve security, the regulator should encourage not only the firms, but also the enterprises to invest in security. I also discuss the effect of network externality and explain why firms engage in "vaporware".
cybersecurity; sequential investment; standards; liability;
- L1: Market Structure, Firm Strategy, and Market Performance
- L8: Industry Studies: Services
TSE Working Paper, n. 14-519, August 2014