Sorting and Grading.

The article develops a theoretical framework to determine the socially optimal way to sort (track) and grade students of heterogeneous ability in secondary education, focusing on how these practices influence students’ incentives to exert effort and their perceived productive value by employers. It finds that an optimal school system either pools all students together or separates them into two ability tiers, with lenient grading applied to top-tier schools and tougher grading to bottom-tier schools, balancing tailored incentives against the informational effects of sorting. When a planner can assign students based on ability (as in Austria or Germany), this two-tier structure emerges if ability variance is large; if students choose schools freely without transfers (as in France or Italy), only random assignment is incentive compatible, but with transfers, a similar two-tier system can be implemented. The study highlights a fundamental trade-off: sorting enables grading policies tailored to student ability, enhancing effort incentives, but also reveals information that can reduce the signaling value of grades, thereby affecting effort.