Countries are seeking innovation-led growth that is more inclusive and more sustainable than in the past. Modern capitalism is facing challenges of climate change, youth unemployment and rising inequality. These challenges require rethinking the role of government and public policy. It requires a new justification of government intervention that goes beyond that of fixing market failures, to one of stimulating and facilitating change by creating markets which more fairly distribute both risk and rewards. This is not just about spending public money on different activities; it requires new indicators through which to evaluate public investments. Markets are 'blind' and the direction of change they provide often represents inefficient resource allocation from a society's point of view. Market failure theory (MFT) justifies government intervention in an economy in order to correct a situation of inefficient resource allocation. This involves taking measures such as devising market mechanisms to internalise external costs or the direct provision of public goods. MFT has developed methods to evaluate government actions, usually through cost-benefit analysis (CBA) – which has limitations in its effectiveness. The CBA then informs an assessment of the 'principal-agent' structure that will force private agents to do what the government wants. Critics of MFT say that it assumes that the government only fixes existing problems and this is not as useful as a policy that creates dynamic new markets or products. However, this can lead to accusations of 'crowding out' private sector businesses. The argument against those criticisms rests on showing how government investments cause both a larger national output that can be shared between private and public sectors, and creates cost savings. However, this argument does not include the idea that the goal of public investment is about more than just increasing output. It should also be, as Keynes wrote, to 'do those things which at present are not done at all'. In fact, new events that have transformed economies have also been influenced on both demand and supply sides by policymaking. The iPhone, Global Positioning Systems (GPS), touch-screen displays, solar power and wind farms, for example, were all publicly funded. Source: RSA Journal, Issue 2, 2015

1. (a)Explain what is meant by the 'principal-agent' problem and describe how it can be applied to governments and private sector businesses.[4]
2. (b)Outline what the article means when it mentions 'inefficient resource allocation'.[4]
3. (c)The article refers to ‘internalising external costs'. Explain what economists mean by this and consider whether cost-benefit analysis can be used to achieve it.[6]
4. (d)Consider whether the article provides sufficient evidence to conclude that market failure theory (MFT) is inadequate as a government policy tool.[6]