CAT 2025 Slot 1 VARC Question & Solution

Reading ComprehensionMedium

Passage

The passage below is accompanied by four questions. Based on the passage, choose the best answer for each question

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.

Question 1

Which one of the options below best summarises the passage?

The passage claims that evaluating the effect of income inequality on economic growth without considering both short- and long-term consequences is misguided

The passage confines its discussion to financing gaps and corporate control while undercutting cross country evidence and overlooking the significance of concerns regarding human capital accumulation, fertility rates, and income redistribution under democratisation.

The passage argues that income inequality accelerates economic growth while also emphasising the significance of concerns regarding human capital accumulation, fertility rates, and political instability.

The passage outlines investment, incentive, and governance channels through which income inequality may support economic growth and reports short-term gains while noting longterm drawbacks

Solution:

Main Idea of the Passage

The passage reviews competing empirical and theoretical perspectives on the relationship between income inequality and economic growth. It first presents arguments and studies suggesting that inequality can promote growth, especially in the short run, through mechanisms such as:

Investment indivisibilities
Incentive effects and moral hazard
Concentrated ownership improving corporate governance

The passage then contrasts these views with a substantial body of evidence showing that income inequality can harm long-run growth, due to factors like:

Reduced investment in human capital
Higher fertility rates among poorer households
Political instability
Greater pressure for redistribution in democratic systems

Overall, the passage adopts a balanced, survey-style approach rather than advocating a single conclusion.

Explanation of the Correct Answer

Why Option D Best Summarises the Passage

Option D accurately reflects the structure and argument of the passage because it:

Correctly identifies the three key channels through which inequality may support growth:
- Investment indivisibilities
- Incentives and moral hazard
- Corporate governance
Captures the important time distinction emphasized in the research:
- Short-term growth benefits
- Negative long-term correlations
Preserves the neutral, evaluative tone of the passage, which compares and contrasts findings rather than endorsing one view

This makes Option D the most faithful summary of the passage as a whole.

Why the Other Options Are Weaker

Option A:
- Is too narrow
- Focuses mainly on the short-run vs long-run distinction
- Misses the detailed discussion of multiple mechanisms and competing explanations
Option B:
- Misrepresents the passage as dismissive of cross-country evidence and redistribution
- In reality, the passage treats these issues as serious and central to the debate
Option C:
- Is misleading because it suggests the passage argues for inequality-driven growth
- The passage actually reports and contrasts evidence on both sides

Final Answer

Correct Answer: Option D

Question 2

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

After the emergency decree, the regime shifted toward authoritarianism as suffrage narrowed and opposition parties were deregistered.

Corporate donations were capped and parties received public funding which was portrayed as establishing an oligarchy.

Municipalities adopted participatory budgeting and recall elections which a press release called totalitarianism.

The coalition imposed term limits and strengthened judicial review in order to further entrench autocratic rule.

Solution:

Main Idea of the Relevant Part of the Passage

The passage explains democratization as the process of expanding suffrage and political participation. As voting rights extend to low- and middle-income groups, political power shifts toward them, which in turn leads to:

Greater support for income redistribution
Expansion of social welfare policies

In short, democratization increases the political influence of the broader population, especially economically weaker groups.

Explanation (Why Option A Is Correct)

Option A represents the opposite of democratization.

Democratization involves widening political participation
Option A describes a move toward authoritarianism, where:
- Suffrage is narrowed
- Opposition parties are deregistered
- Political power is concentrated among a few

This directly contradicts the idea of democratization, which is about inclusion rather than restriction.

Why the Other Options Are Incorrect

Option B:
- Focuses on corporate donations and oligarchic influence
- While problematic, this does not directly describe a reduction in suffrage or voter participation
Option C:
- Mentions participatory mechanisms
- Incorrectly labels them as totalitarianism, which does not align with reduced democratic access
Option D:
- Discusses term limits and judicial review
- These institutional changes do not clearly reduce popular participation or suffrage

Final Answer

Correct Answer: Option A

Question 3

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:

inequality boosts growth in every period and type of economy, regardless of finance or governance conditions.

mature stock markets make wealth concentration unnecessary, yet they might still be harmful to investment.

inequality can aid short-term growth in settings with high sunk costs, incentive alignment, and concentrated ownership.

dispersed ownership speeds corporate decision-making and removes free rider problems.

Solution:

Main Idea of the Relevant Part of the Passage

The first half of the passage explains three mechanisms through which income inequality can positively affect economic growth, especially in the short run:

Investment indivisibilities: Large innovations and projects involve high sunk costs, which are easier to finance when wealth is concentrated.
Incentive / moral hazard effects: Greater inequality can create stronger rewards, motivating effort, risk-taking, and innovation.
Corporate governance: Concentrated ownership helps firms make faster decisions and reduces free-rider problems.

Together, these mechanisms describe specific conditions under which inequality may support economic growth.

Explanation (Why Option C Is Correct)

Option C accurately captures the passage’s argument because it:

Includes all three mechanisms discussed:
- High sunk costs
- Incentive alignment
- Concentrated ownership
Correctly frames inequality’s role as supporting short-term growth
Reflects the passage’s analytical tone rather than making a sweeping claim

The option mirrors the passage’s structure and emphasis, making it the best summary of this section.

Why the Other Options Are Incorrect

Option A:
- Overgeneralizes the claim
- The passage does not argue that inequality boosts growth in all economies or over all time periods
Option B:
- Focuses too narrowly on stock markets
- Ignores investment indivisibilities and incentive effects
Option D:
- Misrepresents the argument
- The passage explains that dispersed ownership can slow decision-making and worsen free-rider problems, which is why concentrated ownership is highlighted as beneficial

Final Answer

Correct Answer: Option C

Question 4

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.

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

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

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

Solution:

Main Idea of the Relevant Part of the Passage

The passage explains the incentive (moral hazard) argument linking income inequality to economic growth. It argues that:

Economic performance often depends on effort that cannot be perfectly observed
If rewards are not tied to performance, individuals may reduce effort
Allowing some income inequality helps align rewards with productivity
This motivates workers, innovators, and entrepreneurs, thereby supporting higher economic growth

Explanation (Why Option A Is Correct)

Option A — pay rewards based on verifiable performance for highly productive workers — directly reflects the incentive mechanism described in the passage.

It links pay to performance
This reduces moral hazard by ensuring effort is rewarded
It creates incentives for higher productivity and innovation

This is exactly the channel through which inequality is argued to enhance growth in the passage.

Why the Other Options Are Incorrect

Option B:
- Increases top incomes without linking them to performance
- Does not address the problem of unobservable effort
- Hence, it does not create effective incentives
Option C:
- Bases pay on tenure rather than output
- Weakens performance incentives and may encourage complacency
Option D:
- Relates to corporate governance and ownership concentration
- This is a different mechanism discussed elsewhere in the passage, not the incentive/moral hazard channel