Suppose two types of firms wish to borrow in the bond market. Firms of type A are in good financial health and are relatively low risk. The appropriate default risk premium over the risk-free rate for lending to these firms is 1%. Firms of type B are in poor financial health and are relatively high risk. The appropriate default risk premium over the risk free rate for lending to these firms is 5%. As an investor, you have no other information about these firms except that type A and type B firms exist in equal numbers.

a. According to Akerloff, at what interest rate you would be willing to buy their bonds if the risk free rate were 5%?

b. What type of asymmetric information problem does this problem illustrate? Explain.