There are three necessary prerequisites for effective self-regulation in any market: there must be an association, it must be motivated...
GMAT Reading Comprehension : (RC) Questions
There are three necessary prerequisites for effective self-regulation in any market:
- there must be an association,
- it must be motivated to regulate its members' behavior,
- it must maintain sufficient powers of control for this purpose.
In respect to stock exchanges, the first condition is undoubtedly satisfied, exchanges being, by definition, associations of member-brokers. As to the third condition, stock exchanges, through their decision-making bodies, have wide powers to discipline members and to make rules protecting investors. Whether the second condition would be satisfied in the absence of existing government regulation is, however, debatable.
In principle, stock exchanges have ample motivation to regulate their members. A failure to curb abuses by member-brokers would deter investors, reducing the volume of trading on an exchange, hence lowering all members' profits. However, brokers are a diverse group of rivals and, as such, will regulate themselves effectively only within a system of checks and balances that fairly harmonizes their conflicting interests. Given sufficient diversity in its makeup and sufficient emphasis on consensual decision-making, the governing body of a stock exchange could provide an adequate check on dishonest practice by powerful individual members of the exchange, or groups of members. There is, however, no evidence to confirm that such a pluralistic model accurately describes stock exchange governance in the real world.
The passage suggests that self-regulation would fail if which of the following were to occur in a stock exchange?
1. Passage Analysis:
Progressive Passage Analysis
| Text from Passage | Analysis |
|---|---|
| There are three necessary prerequisites for effective self-regulation in any market: 1) there must be an association, 2) it must be motivated to regulate its members' behavior, 3) it must maintain sufficient powers of control for this purpose. | What it says: For any market to police itself without government help, three things must be true: there must be a group, the group must want to control bad behavior, and the group must have the power to actually do something about it. What it does: Sets up the entire framework - gives us the three-part test we'll use to evaluate everything that follows. Source/Type: Author's analytical framework (presented as factual requirements) Connection to Previous Sentences: This is our starting point - no previous information to connect to. Visualization: Think of it like a three-legged stool for market self-regulation: • Leg 1: Association exists • Leg 2: Association wants to regulate • Leg 3: Association has power to regulate Remove any leg and the stool (self-regulation) collapses. Reading Strategy Insight: This is your roadmap! The author just told you exactly what to look for in the rest of the passage. Feel confident - you know the structure now. What We Know So Far: The three-part test for self-regulation What We Don't Know Yet: How stock exchanges measure against these three criteria |
| In respect to stock exchanges, the first condition is undoubtedly satisfied, exchanges being, by definition, associations of member-brokers. | What it says: Stock exchanges easily pass test #1 because they are literally groups of brokers working together. What it does: Applies the framework to our specific case and immediately gives us a clear "yes" answer for condition 1. Source/Type: Author's evaluation based on definitional facts Connection to Previous Sentences: This directly applies the first prerequisite from sentence 1 to stock exchanges. This is straightforward application - no new complexity! Visualization: Our three-legged stool for stock exchanges: • Leg 1: Association exists ✓ (stock exchanges = broker associations) • Leg 2: Association wants to regulate ? (still unknown) • Leg 3: Association has power to regulate ? (still unknown) Reading Strategy Insight: One down, two to go! The author is working through the checklist systematically. This should feel orderly, not overwhelming. |
| As to the third condition, stock exchanges, through their decision-making bodies, have wide powers to discipline members and to make rules protecting investors. | What it says: Stock exchanges pass test #3 too - they have the authority to punish bad brokers and create investor protection rules. What it does: Gives us another clear "yes" answer, this time for condition 3, and provides specific examples of these powers. Source/Type: Author's evaluation based on factual observations about exchange powers Connection to Previous Sentences: This applies prerequisite #3 from sentence 1 to stock exchanges. Notice the author skipped #2 and jumped to #3 - we still don't know about motivation. Visualization: Our three-legged stool for stock exchanges: • Leg 1: Association exists ✓ • Leg 2: Association wants to regulate ? (deliberately skipped) • Leg 3: Association has power to regulate ✓ (disciplinary powers, rule-making) Reading Strategy Insight: The author is saving the tricky one for last! Two easy "yes" answers, which means condition #2 (motivation) will be the complex discussion. |
| Whether the second condition would be satisfied in the absence of existing government regulation is, however, debatable. | What it says: Unlike the first two conditions, whether stock exchanges would actually WANT to self-regulate (without government forcing them) is questionable. What it does: Introduces uncertainty and sets up the main debate/complexity of the passage. Source/Type: Author's analytical judgment Connection to Previous Sentences: This contrasts sharply with the certainty of the previous two evaluations. We went from "undoubtedly satisfied" and clear powers to "debatable." Visualization: Our three-legged stool for stock exchanges: • Leg 1: Association exists ✓ • Leg 2: Association wants to regulate ⚠️ (THIS IS THE WOBBLY LEG) • Leg 3: Association has power to regulate ✓ Reading Strategy Insight: Now we know what the rest of the passage will explore - the motivation question. Everything that follows will examine whether leg #2 is strong or weak. What We Know So Far: Stock exchanges pass 2 of 3 tests easily; motivation is the uncertain factor What We Don't Know Yet: The details of why motivation is questionable |
| In principle, stock exchanges have ample motivation to regulate their members. | What it says: Theoretically, stock exchanges should really want to police their members. What it does: Begins exploring the motivation question by presenting the positive side first. Source/Type: Author's logical analysis Connection to Previous Sentences: This starts to unpack the "debatable" motivation from the previous sentence. The phrase "in principle" signals we're about to get theoretical reasoning. Visualization: Think of motivation as having two faces: • Face 1: "In principle" = theoretical motivation (what we're about to learn) • Face 2: Real-world complications (probably coming later) Reading Strategy Insight: "In principle" is a signal phrase - expect the practical reality to be different. Don't be surprised when complications arise. |
| A failure to curb abuses by member-brokers would deter investors, reducing the volume of trading on an exchange, hence lowering all members' profits. | What it says: If brokers behave badly and exchanges don't stop them, investors will leave, trading will decrease, and all brokers will make less money. What it does: Provides the logical chain explaining WHY exchanges should want to self-regulate. Source/Type: Author's cause-and-effect reasoning Connection to Previous Sentences: This explains the previous sentence by showing the logical chain. This is elaboration, not new complexity - it's making the "ample motivation" concrete. Visualization: The motivation chain: Bad broker behavior → Investors scared away → Less trading volume → Lower profits for ALL brokers Therefore: All brokers have incentive to prevent bad behavior Reading Strategy Insight: This is straightforward economic logic. The author is building a clear case for why motivation SHOULD exist before (presumably) explaining why it might not work in practice. |
| However, brokers are a diverse group of rivals and, as such, will regulate themselves effectively only within a system of checks and balances that fairly harmonizes their conflicting interests. | What it says: But here's the problem: brokers compete with each other and have different interests, so they'll only self-regulate well if there's a fair system that balances everyone's competing needs. What it does: Introduces the first major complication to the theoretical motivation. Source/Type: Author's analytical observation about group dynamics Connection to Previous Sentences: "However" signals the turn - this contrasts with the simple logic chain we just learned. Theory says they should cooperate; reality says they're competitors with conflicts. Visualization: Imagine 50 competing pizza shops trying to agree on neighborhood rules: • Big shops want different rules than small shops • Downtown shops want different rules than suburban shops • They all compete for the same customers • They need a fair system to make decisions, or the powerful shops will dominate Reading Strategy Insight: This is the classic "collective action problem" - what's good for the group requires individuals to cooperate despite competing interests. |
| Given sufficient diversity in its makeup and sufficient emphasis on consensual decision-making, the governing body of a stock exchange could provide an adequate check on dishonest practice by powerful individual members of the exchange, or groups of members. | What it says: If the exchange's governing board includes many different types of members and makes decisions through consensus, it could effectively prevent powerful brokers or broker groups from cheating. What it does: Offers a potential solution to the rivalry problem mentioned in the previous sentence. Source/Type: Author's conditional prediction about governance solutions Connection to Previous Sentences: This addresses the "checks and balances" mentioned in the previous sentence by describing what those might look like. This is solution-focused, building on the problem identification. Visualization: Effective exchange governance requires: • Diverse governing board (not dominated by one type of broker) • Consensus decision-making (not majority rule by powerful players) • Result: Even powerful brokers can be controlled Reading Strategy Insight: The word "could" is key - this is theoretical possibility, not proven reality. We're still in the realm of what might work in ideal conditions. |
| There is, however, no evidence to confirm that such a pluralistic model accurately describes stock exchange governance in the real world. | What it says: But we have no proof that stock exchanges actually operate with this kind of diverse, consensus-based governance in reality. What it does: Delivers the final blow to the self-regulation argument by noting the lack of real-world evidence. Source/Type: Author's factual observation about available evidence Connection to Previous Sentences: "However" signals another contrast - this definitively undermines the theoretical solution just described. We went from "could work" to "no evidence it actually does." Visualization: Our final assessment of the three-legged stool: • Leg 1: Association exists ✓ (strong) • Leg 2: Association wants to regulate ❌ (wobbly - theory says yes, reality unclear) • Leg 3: Association has power to regulate ✓ (strong) Result: The stool (self-regulation) is unstable Reading Strategy Insight: This concludes the author's systematic analysis. We're back to the original framework with a clear conclusion: 2 out of 3 conditions met, but the missing one (motivation) is crucial. What We Know So Far: Complete analysis showing self-regulation is theoretically possible but practically unproven Final Takeaway: Stock exchanges fail the three-part test due to questionable real-world motivation |
2. Passage Summary:
Author's Purpose:
To evaluate whether stock exchanges can effectively regulate themselves without government oversight by applying a three-part test for self-regulation.
Summary of Passage Structure:
In this passage, the author builds their analysis by systematically testing stock exchanges against a clear framework:
- First, the author establishes a three-part test for effective self-regulation: there must be an association, it must want to regulate its members, and it must have the power to do so.
- Next, the author applies this test to stock exchanges, quickly confirming that exchanges easily pass two of the three conditions - they are associations by definition and they have clear disciplinary powers.
- Then, the author focuses on the problematic second condition (motivation), explaining that while exchanges should theoretically want to self-regulate to protect profits, the reality is more complex because brokers are competitors with conflicting interests who would need fair governance systems to regulate effectively.
- Finally, the author concludes by pointing out that there's no real-world evidence that stock exchanges actually operate with the kind of balanced, consensus-based governance that would be needed for effective self-regulation.
Main Point:
Stock exchanges cannot be relied upon to regulate themselves effectively because, while they have the structure and power needed for self-regulation, there's no evidence they have the proper motivation and governance systems to actually do it fairly in practice.
3. Question Analysis:
The question asks us to identify what would cause self-regulation to fail in a stock exchange. This is asking us to find a scenario that would break one of the three necessary prerequisites for effective self-regulation that the author established.
Connecting to Our Passage Analysis:
From our passage analysis, we know:
- The author established three prerequisites for self-regulation: association, motivation, and power
- Stock exchanges easily pass two tests (association and power) but struggle with the second (motivation)
- The motivation problem centers on the fact that "brokers are a diverse group of rivals" who need "a system of checks and balances that fairly harmonizes their conflicting interests"
- The solution requires "sufficient diversity in its makeup and sufficient emphasis on consensual decision-making" in the governing body
- The key threat is "dishonest practice by powerful individual members of the exchange, or groups of members"
Prethinking:
Since two of the three prerequisites are solid for stock exchanges, the question is likely testing our understanding of what would undermine the problematic second condition (motivation). Based on our analysis, self-regulation would fail if the governance system became unfair or dominated by powerful interests, preventing the "checks and balances" needed to control conflicts among rival brokers. We should look for an answer that describes a breakdown in fair, diverse governance.
Why It's Wrong:
• This describes a consequence of failed self-regulation, not a cause of it
• According to the passage, decreased trading volume would actually motivate exchanges to regulate better, not cause regulation to fail
• The passage states that reduced trading volume would lower "all members' profits," which should strengthen their motivation to self-regulate
Common Student Mistakes:
Didn't the passage say that reduced trading volume is bad for exchanges?
→ Yes, but that's exactly why it would motivate them to regulate better, not cause regulation to fail
Isn't this talking about investor behavior, which the passage mentions?
→ The passage discusses how investor deterrence motivates regulation, not how it prevents regulation
Why It's Right:
• This directly undermines the "checks and balances" system that the passage identifies as essential for self-regulation
• It violates the requirement for "sufficient diversity in its makeup" in the governing body
• It creates exactly the scenario the passage warns against: powerful groups dominating decision-making
• This would prevent the "consensual decision-making" that the author says is necessary
Key Evidence: "Given sufficient diversity in its makeup and sufficient emphasis on consensual decision-making, the governing body of a stock exchange could provide an adequate check on dishonest practice by powerful individual members of the exchange, or groups of members."
Why It's Wrong:
• This describes members outside the governing body organizing, which doesn't threaten the governance structure
• The passage's concern is about powerful groups within the governing body, not outside it
• Members defending common interests could actually support self-regulation rather than undermine it
Common Student Mistakes:
Doesn't the passage worry about groups of members causing problems?
→ Yes, but specifically "powerful individual members of the exchange, or groups of members" within the governing structure
Isn't any kind of member cooperation potentially problematic?
→ The issue is domination of decision-making power, not cooperation among equals
Why It's Wrong:
• This discusses investor psychology but doesn't address the three prerequisites for self-regulation
• The passage focuses on structural governance issues, not individual investor perceptions
• Investor profit-seeking behavior doesn't impact whether exchanges can regulate their members
Common Student Mistakes:
Doesn't the passage emphasize the importance of investor confidence?
→ Yes, but as motivation for exchanges to regulate, not as a structural requirement for effective regulation
Wouldn't unfair investor perceptions hurt the market?
→ This choice describes investor behavior, not exchange governance failures that prevent regulation
Why It's Wrong:
• Allowing members to question decisions actually supports democratic governance and checks and balances
• This would enhance the "consensual decision-making" that the passage advocates
• The ability to question decisions is consistent with, not contrary to, effective self-regulation
Common Student Mistakes:
Wouldn't questioning decisions create instability in governance?
→ The passage advocates for consensual decision-making, which requires discussion and input, not blind obedience
Doesn't this suggest lack of control by the governing body?
→ Effective self-regulation requires member buy-in and fair processes, not authoritarian control