Why do students compete for grades? An obvious answer is that they want higher scores so that they can get into graduate school or look more attractive to recruiters from consulting companies. Higher grades lead to more bucks earned after graduation.
What's interesting is that it doesn't take very much inequality to get students to ramp up the hours studying:
A mere 12% increase in score induces some students to knock themselves out to get an A rather than a B!
Of course, the rewards for getting an A are more than just the numerical gain; being scarce, A's offer huge psychic rewards as well as potential pecuniary rewards greater than 12%.
In the raging debate over income inequality the argument is often presented that unequal incomes spur productive behaviors that otherwise would be withheld for lack of incentive. This is surely true, but the advocates of this viewpoint have little empirical evidence to argue that a "huge" difference is needed to spur that activity.
Rather, people fight heroically over quite small differences in rewards—primarily because the reward itself is a symbol of social standing or intrinsic excellence. Some students, for example, want to view themselves as masters of the material or essential lovers of the subject and will work for no "pay" (e.g., they audit or do extra work).
In the wider world Adam Smith argued that the most ambitious businessman really just wants recognition for the rivalry involved or the excellence of the work. Hence, the "necessity" of social recognition promotes profound exertions, without requiring huge financial rewards (e.g., "great objects"):
In every profession, the exertion of the greater part of those who exercise it, is always in proportion to the necessity they are under of making that exertion…. The greatness of the objects which are to be acquired by success in some particular professions may, no doubt, sometimes animate the exertion of a few men of extraordinary spirit and ambition. Great objects, however, are evidently not necessary in order to occasion the greatest exertions. Rivalship and emulation render excellency, even in mean professions, an object of ambition, and frequently occasion the very greatest exertions (Wealth of Nations, Liberty Fund Edition, 493-494).
What is the lesson? Those who advocate for equal distribution of rewards—there are not many in this day and age—are sadly misguided, and perhaps misunderstand human nature. Inequality is good—but here's the main point—huge inequality is not necessary to bring out the human passion for exceling and competing. This does not constitute an argument in favor of government distribution, but presents a counter-argument to those who proclaim as "fact" something that is apparently untrue.
Large inequality is not necessary for markets to function. At least, that's the lesson [from grading] in my classroom. But there would be a riot if points were not awarded "fairly" according to the contract in the syllabus! So justice first, and mild inequality second, are the prerequisite institutions needed. [Clarification added.]