Question 1: (Asymmetric information and the lemon market) Consider an economy with a bank and two types of firms, good firms and bad firms. Both firms need bank loans to finance their investments. Suppose that good firms are always able to repay the loans, whereas bad firms only repay the loans with probability of 80% (i.e., in 20% of the cases, bad firms default and pay the bank nothing). Now, the bank provides a one-period commercial loan at face value $10,000 to a good firm. The loan rate, re, is 10%. For question a) and b): Assume that the bank is able to distinguish between the two types of firms (i.e., the bank knows if they are lending to a good firm or to a bad firm, and the default rate of a bad firm). a) Calculate the minimal loan rate, rg, the bank would charge if it lent $10,000 to a bad firm. (Hint: Calculate the expected cash flows from a given loan and apply the principle of present value.) b) Is rg larger or smaller than rc? Give your intuition. Now if the bank is unable to distinguish between the two types of firms (i.e., there is asymmetric information). Initially, the number of good firms who apply for a loan is the same as that of bad firms in the market. c) If the bank lent $10,000 to a firm, would the loan rate be higher / lower / equal to rg and ro, respectively? Give your intuition. d) How does the change in loan rate affect good firms' incentive of borrowing? e) What would be the market loan rate in the end (in equilibrium)