On what basis do you think students should be graded? What should a grade reflect, anyway?
There are at least three obvious answers: ability, effort, and improvement (i.e. how much the student has actually learned). As I see it, in order to decide which is most appropriate, we should consider how grades are used. For whatever grades measure, it seems clear to me that grades are and should be a kind of measurement: they should provide some sort of information about the student. So we should try to maximize the usefulness of grades as measurements.
From this perspective, it's surely most appropriate that grades measure ability, independent of effort or improvement. Suppose, for example, that I'm reviewing applications for a programming job. If an applicant got an A in real analysis in college, and that A accurately reflects her ability, I can say "This character is good at math", which is clearly worth knowing in this situation. Possibly the applicant already knew analysis before taking the course, and so she didn't even bother showing up to class or doing the homework; she just took the tests. Thus she exerted minimal effort and got basically nothing out of the course. But that makes no difference as far as I'm concerned, because in general, I care only about what abilities she can bring to the job, not how she got them.
Some people seem to view grades as a reward or a tool for motivation. They would err on the side of grading on the basis of effort in order to motivate everyone to work hard. I don't like this. It interferes with the informational function of grades.
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"As for me, I can neither drum nor trumpet, nor tell jokes, nor fart amusingly at parties, nor play the harp."
I agree that they ought to represent ability, because their purpose is to evaluate whether one is ready for X class or Y job.
Edit: As a forward, this argument is only tangentially related to the subject matter. Because grading is so subjective, it may convey little information to employers. It may be better to have grades reflect only one thing- this doesn't suggest that grading should not reflect only one thing (like ability), only that, as such, grading is not very useful. It may be more useful if it is understood to be only a reflection of ability than if it is understood to be a mysterious method of assigning letters or numbers to people. But it would still not be very useful.
Having high scores based on ability does not make one more suitable for employment, if one's efforts are minimal, or improvement is nil, unless your job just happens to be doing exactly what you did in class.
Most jobs, however, are more involving than classwork. Someone who happens to be good at class without trying won't necessarily succeed in an environment that requires training above what class teaches.
If Jane gets A's in all of her classes but puts in no effort and learns nothing, she may be better than Jill [in terms of employability], who gets B's and puts in a lot of effort and improves readily. But, as an employer, it is not an easy call. Jill, clearly, has demonstrated an ability to put in effort and have a willingness to learn new things. Jane may or may not. Jill may surpass Jane in a progressive career. Jane may go stagnant and neither have a willingness to learn new things, nor put effort into what she does. Relegating her to accomplishing no more than she did in Math 300, whilst Jill masters real life and becomes a far superior employee.
Then, basing everything on ability alone would be shortsighted and superficial.
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I guess the question then becomes which is safer to generalize from, demonstrated ability in a certain subject or demonstrated capacity for improvement in a certain subject. Which is an empirical question.
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"As for me, I can neither drum nor trumpet, nor tell jokes, nor fart amusingly at parties, nor play the harp."