Suppose Joe Has a Two-Year Old Honda Civic That's in Excellent

question 44

Multiple Choice

Suppose Joe has a two-year old Honda Civic that's in excellent condition and that he would be willing to sell for $13,000. Lauren, who is risk-neutral, is considering whether to buy Joe's car. She's willing to pay $14,000 for a two-year Honda Civic that's in excellent condition and only $10,000 for one that's not in excellent condition. Lauren cannot tell whether Joe's car is in excellent condition. She believes that only 20 percent of two-year old Hondas for sale in the market are in excellent condition and that the other 80 percent are not in excellent condition. If Joe offers a warranty in which he makes a legally binding commitment to pay for any major repairs the car needs in the next 18 months, then this ________ serve a credible signal because ________.

• A)will; it is more costly for people with low-quality cars to offer such a warranty
• B)will; people who own cars that are in excellent condition are usually honest
• C)will not; it is less costly for people with low-quality cars to offer such a warranty
• D)will not; people who sell used cars are rarely honest

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Definitions:

Real Interest Rate

Adjusted interest rate for inflation, reflecting the true cost of borrowing or the real yield on savings.

Nominal Interest Rate

The interest rate before adjustments for inflation, representing the raw interest percentage that lenders charge borrowers for the use of money.

Inflation Rate

The speed at which the aggregate price level for goods and services goes up, undermining the power of purchasing.

Nominal Interest Rate

The rate of interest before adjustments for inflation; the stated rate on a loan or investment.