It is argued [11, 13] that negligence rules are required to force software vendors to act optimally. However, the effects of reputation and the marginal cost effect from reduced sales are incentives in themselves for the vendor to act optimally. The supply of imperfect information to the vendor through incomplete and inadequate feedback channels is a problem that can be solved in part through the creation of a market for vulnerability research. The effects of reputation on the vendor and the assignment of risk through this process result in fewer negative externalities then occur because of a legislative approach.
There are good reasons for this allocation of risk. What little the software vendor can do is generally already being expressed (as noted, the vendor has an interest in reducing the damage to their reputation). That is C(Omega), is already as close to the optimal level as is economically efficient for all parties, whereas C(Omega)[i] can be easily achieved through the user's self-insurance (through mitigation, controls etc). The user has a better idea of the environment and uses that they intend to expose the software. Hence, the user is a better estimator (and reducer) of consequential damages than the software vendor.
The level of damages suffered by a user depends on both the pre-breach behavior of the user and the vendor. The vendor is in a position where reputation influences sales (demand) and hence the willingness to add layers of testing and additional controls (all of which increase the cost of the software). As the market for software varies in its elasticity [11, 19] from the highly inelastic in small markets with few competitors (e.g. Electricity markets) to highly elastic (e.g. Games), the user has the ability to determine their needs in the best manner. The user may select customized software with warranties designed to reduce the levels of breach that can occur [11, 13]. This comes with an increased cost.
Software vendors (unless specifically contracted otherwise) do not face strict liability for the damage associated with a breach due to a software vulnerability. Although negligence rules for software vendors have been called for , this creates a sub-optimal outcome. The user can (excepting certain isolated instances);
- select different products with an expectation of increased security ,
- add external controls (through the introduction of external devices, create additional controls or use other software that enhances the ability of the primary product),
- Increase monitoring for attacks that may be associated with the potentially vulnerable services (such as by the use of an IDS).
The software vendor could offer to be liable for consequential damages (where they would guarantee losses for all software flaws) but this would increase the cost of the testing process. As there is no way to ensure and hence guarantee the security of software [12, 20] (this is, make it bug free), there is no way for the vendor to be certain they have found all the flaws in their software. As each possible bug is discovered, the amount of effort required to find the next bug increases geometrically [17, 20].
The software vendor could insure for these losses and offer consequential damages to the user. This would entail a greater cost. The fact that few users seek out vendors that are willing to provide (and that few users would be willing to pay for) this level of assurance is strong evidence that the users are unwilling to pay for the extra costs that such a level of liability would entail. Industry custom is generally a high-quality indicator of the efficient allocation of liability in contracts in the absence of trade restrictive government regulation. Software markets involve bargaining and contractual negotiation where costs can be efficiently transferred to third parties .
A market system for the discovery of bugs is at a comparative disadvantage as the tester does not have access to either source code (in general) and is constrained through existing legislative instruments (such as the US DMCA) that make the reverse engineering of software expensive and in some instances illegal. The large number of potential vulnerability researchers as well as the existing pool of researchers adds both opportunities from organized companies and for the creation of new ventures. This has an additional consequential benefit in that many of the potential criminal recruits (into cybercrime organizations) are also the same people that could become vulnerability researchers.
This leads to an optimal level of allocation to the role of vulnerability researcher and decreases the supply of recruits to criminal organizations. This has a consequential side effect of increasing the marginal costs to cybercrime making it more expensive for criminals to conduct their actions. The increase in costs for criminal organizations moves the indifference curves and consumption optimums of the cybercrime organization in a way that reduces crime.
Blanchard & Fabrycky  remind us that:
Software has an "agency problem" that can be associated with production, shrink wrapped software moves issues that an internal production house would mitigate into the mainstream. In regards to the rise of the shrink-wrapped software industry, Brookes  notes:
For the developer in the shrink-wrapped industry, the economics are entirely different from those in the classical industry: development cost is divided by large quantities; packaging and marketing costs loom large. In the classical in-house development industry, schedule and the details of function where negotiable, development cost might not be; in the fiercely competitive open market, schedule and function quite dominate development cost.
Brooks  further asserted that the distinct development environments of in-house and shrink-wrapped software give rise to divergent programming cultures. Shrink-wrapped software can cost a percentage of the cost of developing software in-house. Even when large numbers of users run the same software (such as Microsoft Word in many organizations), the costs of developing the software in-house is generally a three times the cost  of an equivalent off-the-shelf package.
Even in-house developed software is not bug free. The truth of the matter is that in-house software is more likely to contain bugs on release . As the development costs are generally fixed in in-house development projects, failures that result in schedule slippages commonly result in cuts to the testing and debugging stages of the project. This disastrous effect leads to more bugs in the final product.
In-House software may seem to have a lower rate of bugs/vulnerabilities, but the truth of the matter is that the more users of the software exist, the greater the number of bugs that will be uncovered in any period. This may seem to add a beneficial aspect to in-house developed software, but the interconnectivity of systems greatly increases the number of people that can find a software bug in the application. The distinction is that external parties will have a far lower rate of reporting than internal users (this is, attackers will sit on a discovered vulnerability and maintain this as a zero-day attack path against the organization).
Widely deployed shrink-wrapped software on the other hand is likely to have the same or less than the number of bugs, that is:
# Bugs in Shrink-ware software <= bugs in In-House software
The issue comes from the costs of minimizing software bugs. The costs of conducting program verification are generally 10x the cost of developing the software. As shrink-wrap software is generally a third of the cost of in-house software (for mainstream applications), the cost of developing secure software comes to over 30x the cost of an off-the-shelf product. Solutions that are more reasonable can be deployed to minimize the losses associated with the bugs. Hence, it is rarely cost effective to ensure that software is perfect.
2. Arora, A., Telang, R. & Xu, H. (2004) “Optimal Time Disclosure of Software Vulnerabilities”, Conference on Information Systems and Technology, Denver CO, October 23-2; See also Arora, A. &; Telang, R. (2005), “Economics of Software Vulnerability Disclosure”, IEEE Security and Privacy, 3 (1), 20-2
4. Blanchard, B.S., & Fabrycky, W. J., (2006) “Systems Engineering and Analysis”. 4th ed. Upper Saddle River, N.J.: Pearson Prentice Hall
7. BeyondTrust Software (2010) “BeyondTrust 2009 Microsoft Vulnerability Analysis: 90% of Critical Microsoft Windows 7 Vulnerabilities are Mitigated by Eliminating Admin Rights”, http://www.beyondtrust.com/downloads/whitepapers/documents/wp039_BeyondTrust_2009_Microsoft_Vulnerability_Analysis.pdf
8. Brookes, F. (1995) “The Mythical Man-Month”. Addison-Wesley
11. Donald, D. (2006), "Economic Foundations of Law and Organization" Cambridge University Press
13. Durtschi, C., Hillison, W., & Pacini, C. (2002) “Web-Based Contracts: You Could Be Burned!” Journal of Corporate Accounting & Finance, Volume 13, Issue 5 , Pp 11 – 18.
17. Mills, H. D. (1971) "Top-down programming in large systems", Debugging techniques in large systems, R. Rustin Ed., Englewoods Cliffs, N.J. Prentice-Hall
18. Reed, Chris (2004) “Internet Law Text and Materials”, 2nd Edition, Cambridge University Press, UK
19. Stolpe, M. (2000). Protection Against Software Piracy: A Study Of Technology Adoption For The Enforcement Of Intellectual Property Rights. Economics of Innovation and New Technology, 9(1), 25-52.
20. Turing, Alan (1936), “On computable numbers, with an application to the Entscheidungsproblem”, Proceedings of the London Mathematical Society, Series 2, 42 pp 230–265