Reading Comprehension

Economy

Hard

Studies showing that income inequality plays a positive role in economic growth are largely based on three arguments. The first argument focuses on investment indivisibilities wherein large sunk costs are required when implementing new fundamental innovations. Without stock markets and financial institutions to mobilize large sums of money, a high concentration of wealth is needed for individuals to undertake new industrial activities accompanied by high sunk costs . . . [One study] shows the relation between economic growth and income inequality for 45 countries during 1966-1995. [It was found] that the increase in income inequality has a significant positive relationship with economic growth in the short and medium term. Using system GMM, [another study estimated] the relation between income inequality and economic growth for 106 countries during 1965–2005 period. The results show that income inequality has a positive impact on economic growth in the short run, but the two are negatively correlated in the long run. The second argument is related to moral hazard and incentives . . . Because economic performance is determined by the unobservable level of effort that agents make, paying compensations without taking into account the economic performance achieved by individual agents will fail to elicit optimum effort from the agents. Thus, certain income inequalities contribute to growth by enhancing worker motivation . . . and by giving motivation to innovators and entrepreneurs . . . Finally, [another study] point[s] out that the concentration of wealth or stock ownership in relation to corporate governance contributes to growth. If stock ownership is distributed and owned by a large number of shareholders, it is not easy to make quick decisions due to the conflicting interests among shareholders, and this may also cause a free-rider problem in terms of monitoring and supervising managers and workers. . . .

Various studies have examined the relationships between income inequality and economic growth, and most of these assert that a negative correlation exists between the two. . . . Analyzing 159 countries for 1980–2012, they conclude that there exists a negative relation between income inequality and economic growth; when the income share of the richest 20% of population increases by 1%, the GDP decreases by 0.08%, whereas when the income share of the poorest 20% of population increases by 1%, the GDP increases by 0.38%. Some studies find that inequality has a negative impact on growth due to poor human capital accumulation and low fertility rates . . . while [others] point out that inequality creates political instability, resulting in lower investment. . . . [Some economists] argue that widening income inequality has a negative impact on economic growth because it negatively affects social consensus or social capital formation. One important research topic is the correlation between democratization and income redistribution. [Some scholars] explain that social pressure for income redistribution rises as income inequality increases in a democratic society. In other words, when democratization extends suffrage to a wider class of people, the increased political power of low- and middle-income voters results in broader support for income redistribution and social welfare expansion. However . . . if the rich have more political influence than the poor, the democratic system actually worsens income inequality rather than improving it.

According to the incentive or moral hazard argument, which one of the designs below is most consistent with the claim that some inequality can raise growth?

Pay rewards on verifiable performance for highly productive workers.

Wages are determined by tenure rather than output to ensure equity.

A regime that concentrates stock ownership in relation to corporate governance.

Rents protected by market power that enlarge top incomes without linking pay to results.

✅ Correct Option: 1

The correct answer is option 1. The passage's moral hazard and incentive argument, presented in the second argument of the first paragraph, states that "paying compensations without taking into account the economic performance achieved by individual agents will fail to elicit optimum effort." The logic is that linking pay to observable performance elicits greater effort, thereby contributing to growth. Option 1, which ties pay rewards to verifiable performance for highly productive workers, directly mirrors this mechanism: compensation is contingent on measurable output, creating the inequality-driven incentive the passage describes.

Option 2 is wrong (reversed). Determining wages by tenure rather than output is precisely the kind of compensation structure the moral hazard argument warns against. The passage says that ignoring individual economic performance in pay decisions fails to elicit optimum effort, so tenure-based pay contradicts rather than supports the incentive claim.

Option 3 is wrong (keyword trap). Concentrating stock ownership in corporate governance is indeed discussed in the passage, but it belongs to the third argument about corporate governance and free-rider problems, not to the moral hazard and incentive argument. The question specifically asks about the incentive argument, so this option attaches a valid passage concept to the wrong reasoning strand.

Option 4 is wrong (out of scope). Rents protected by market power that enlarge top incomes without linking pay to results introduce a scenario the passage never endorses. The moral hazard argument requires a connection between compensation and performance; option 4 explicitly severs that link, making it incompatible with the claim that performance-based inequality raises growth.

Question 19

The passage refers to "democratization". Choose the one option below that comes closest to the opposite of this process.

Question 20

The primary function of the three-part case for a positive income inequality–economic growth link in the first half of the passage is to show that:

Question 21

Which one of the options below best summarises the passage?

According to the incentive or moral hazard argument, which one of the designs below is most consistent with the claim that some inequality can raise growth?

Solution

More from this set:

Keyboard Shortcuts

CAT Past Year Questions (Topic-Wise)