Consider the example in Chapter 7 of two firms that want to issue bonds. Assume as before that a firm makes the promised payment on a bond only if its project succeeds.
a. Suppose the government guarantees the firms’ bonds: it makes the promised payment if either firm defaults. Can both firms sell bonds? What payments must they promise?
b. What is the average cost to the government of guaranteeing a bond, assuming it does so for each firm?
c. What is the average profit on an investment project, assuming both firms finance their projects with government-guaranteed bonds?
d. Which is higher, the average cost of a bond guarantee (part (b)) or the average profit on a project (part (c))? In light of this comparison, do the guarantees promote economic efficiency? Explain why or why not. (Hint: How do the guarantees affect the adverse selection problem?)