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Grade retention is a major issue in the ongoing debate over how to improve primary and secondary education in the United States. This paper examines the retention decision and its empirical effects using an economic framework. Within our model, the retention decision is endogenous with respect to such observables as dropping out of school and labor market earnings and this endogeneity needs to be accounted for in empirical work. In the empirical section of the paper we use the High School and Beyond (HSB) data set to examine the effects of retention on the probability of dropping out of high school and on labor market earnings several years after the student has entered the workforce. We account for the endogeneity of grade retention by using instrumental variables (IV) estimation where the key instrument is based on exogenous variation across states in kindergarten entry dates.