UC Merced

Innovation is a very important concern for both managers and governmental policy makers. There is an important interplay between security and technology innovation that is largely unrecognized in the literature. This research considers the case where technology innovation in the form of additional product features increases demand through greater functionality. However, the likelihood of a security breach increases with the number of product features as the features interact in unintended ways, thereby increasing the attack surface. Using a two-stage game, we demonstrate how potential demand changes (from direct risk or externalities) impact firm technology innovation strategy. The analysis shows that the type and extent of customer demand reaction has a significant impact on innovative feature development. This research identifies two potential impacts on the level of innovation that can be strategically managed - the impact of externalities on demand and industry risk - explaining how these forces alter the level of innovation in the product ecosystem. Additionally, high-security development is disincentivized, and leads to a type of competitive behavior where the opportunity window for high-security development for all firms is small.