I'd like to respond to a few of your points.
I find myself not as bright as those who I have seen being very successful. I still try to do as much as I can, hoping that my efforts will be enough.
I didn't get into the IITs after my 12th and thought myself not smart and hardworking enough to do well at an IIT, leave alone at research. Many years and plenty of twists and turns later, I'm now a graduate student at a well-regarded and extremely selective US university. I have a small number of papers, some of which even get cited every now and then (!) and a couple of patents. The main thing I learned from all this is that in research it's not very important to be smart, because I see people smarter than me all the time, what's important is to actually like what you're doing sufficiently that you enjoy thinking really hard about it.
lack of research output may be because the brightest of UG students get into US universities where there are better research groups and opportunities. Or may be because other engineering colleges from where the PG students have completed their Undergraduate programs didn't offer as much as IITs (or US universities do).
There's a combination of factors here. Many good students do choose to go the US/Europe over India and I can sort of see why they do that. Life, in general, sucks a little less here, the professors are little better, opportunities are a little easier to get, and of course, a good job after graduation is significantly easier. I studied at IISc and got to know quite a few faculty there and at a couple of IITs. I feel that the Indian system is improving rapidly and there are many good professors who are doing excellent research at IISc and the IITs. Having said that, I think that some things are still harder to do in India, and some professors are still very mediocre and some still harbour rather regresive views on how research should be done. A generation or two from now I expect things will be a lot better.
It is unfair to compare IITs with other institutes, there are a lot of factors at play. Sure, we want high paying jobs - but if they are available who won't? Think about the socio-economic pressure on the students as well. For a middle income family most salaries that are offered to IIT graduates will bring about a significant change in lives of these students as well as their families. It might be a different case in US (and other countries) but a lot of us face these issues. I was lucky that I don't, but I know many students with parents who will feel happier if their child settles down with a high paying job and not pursue higher education for another 2 - 5 years.
This is an excellent point.
We're still at that phase in our development where it's more important to ensure economic security for oneself so that one is guaranteed a reasonable standard of living. Foregoing these "high-paying jobs" and doing research, in effect, means accepting a significantly lower standard of living and it's completely unreasonable to expect people to do that in a still-developing country like India.