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In my experience . . . they know. When I was in elementary school, they had us in different reading groups, and the groups were named after birds depending on which reader we were using (the one with the blue cover was for the "bluebirds" group, etc.), rather than "A, B, C" or "1, 2, 3" or whatever. It may have been somewhat more polite, but everybody knew that some groups were getting "Let's go for a ride! I like to rid in the car!" and some were getting "Susan wasn't sure what her mom would say about the broken vase, so she decided to not say anything."
Like the baseball/softball league my kids play in... up to 8 they give out a little trophy or medal to everybody. (But it just says "Podunk Little League Rookie Division, 2008"... Not "#1 Champions or something like that.) Hell, they barely keep score, much less standings. The emphasis is on teaching the kids how to play--when do you throw it to first? when do you throw it to second? Etc. For the two older age groups, there are playoffs and trophies for the champions and first runner-ups. The kids know the difference between the "thanks for showing up" trophies and the championship ones.
I admit I haven't finished the book (yet), but in "The Optimistic Child," psychologist Martin Seligman says that the problem isn't the idea of building self-esteem, but the way it's done. Bad: Tell the kids they're geniuses no matter how bad they screw up. (It doesn't work and they can tell they've screwed up.) Good: Put them in a position where they can actually achieve something or be successful at something.
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