By Evan R. Goldstein

In 1995, George A. Akerlof, a professor of economics at the University of California at Berkeley, circulated a working paper on the impact of social class and conformity on decision making. Akerlof argued that people make decisions—demand education, practice discrimination, marry, divorce, have children, and so on—based in large part on external factors, such as the quest for peer status.

A short time later, Akerlof received a letter from Rachel E. Kranton, a former student who was then an assistant professor of economics at the University of Maryland at College Park. The paper, she wrote, was flawed because it overlooked the role of identity in determining economic outcomes.

"I wouldn't call it chutzpah," Kranton says about her letter to Akerlof. Whatever the case, Akerlof was displeased. He also thought Kranton was wrong. "I understood identity as an aspect of people's tastes," he recently recalled, "and economists had already incorporated taste into their theories."

Despite his skepticism, Akerlof, who was awarded the Nobel Memorial Prize in Economic Science in 2001, felt he owed Kranton an opportunity to explain herself. They met at the Brookings Institution, in Washington, where Akerlof was ensconced as a resident fellow while his wife, Janet L. Yellen, served on the Federal Reserve Board. (Yellen, a much-rumored candidate to become the first woman to chair the Federal Reserve Board, is currently president of the Federal Reserve Bank of San Francisco.)

Over lunch, Kranton explained her ideas about identity, which originated in Middle East studies—"a field," she says, "that has grappled with questions about how communities are defined." Her husband, Abdeslam E. Maghraoui, is an associate professor of political science at Duke University and a scholar of political identity in the Muslim world. "Identity looms large in the intellectual discourse of my family," Kranton says over the phone from her office at Duke, where she is a professor of economics.

By the end of the meal, Akerlof was convinced that Kranton was on to something significant. "The important part about an idea," he tells me, "is the intuition that something isn't being done." But several questions remained. What exactly is identity? And how could it be incorporated into economics?

They began to meet frequently and read widely in the humanities and social sciences. The work of the Italian sociologist Vilfredo Pareto, who died in 1923, was particularly influential. Pareto's basic observation, Akerlof explains, was that people "don't just care about economic things, they also care about what they should and should not do, and those beliefs are shaped by who they think they are."

Akerlof points to the persistence of taboos against homosexuality. "These views, which are very arbitrary and cause a great deal of unnecessary pain and suffering, are not well captured in standard economics." People's senses of who they are shape their ideas about how they, and others, should behave. Those beliefs, moreover, change with time. For instance, a young mother in the early 1960s faced a very different choice about whether to pursue a career than do her contemporary counterparts. "Once we saw that"­—Akerlof calls it an "Aha!" moment—"we could see how identity applies to almost all areas of human motivation, from the behavior of children riding on a merry-go-round to how CEO's operate."

In 2000, Akerlof and Kranton formally introduced identity into economics in a paper published in the Quarterly Journal of Economics. "Because identity is fundamental to behavior, choice of identity may be the most important 'economic' decision people make," they wrote. More papers followed. Now Princeton University Press is publishing a book-length treatment of Akerlof and Kranton's ideas, Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being. "Identity economics is at the frontier," they write. "We change economics by closely observing economic and social life and transforming existing theory."

Identity economics, according to Akerlof and Kranton, is both a continuation of and a departure from other developments in the field over the last half-century that have brought economics closer to reality. Game theory allows for a more supple analysis of everything from marriage to monetary policy, and behavioral economics incorporates psychology into the discipline, highlighting the predictable irrationality of human behavior. And since the publication of Gary Becker's groundbreaking book The Economics of Discrimination in 1957, economists have taken up the study of social issues, like fertility, crime, and punishment.

But while Becker and his disciples account for some noneconomic motivations, they generally assume such tastes to be universal and static. Akerlof and Kranton, however, argue that taste is largely dependent on social context. "Taste has been taken as a given, and economists weren't supposed to explore where they come from and how they change. But taste is not a cultural constant," Kranton tells me. "Once you recognize that, you have a different view of how people will act in certain circumstances."

Imagine a new cadet at West Point. On his first day, he is given a haircut, stripped to his underwear, put in a uniform, and forced to endure a number of arduous rituals, like saluting and repeating the same phrase over and over again. Why? The cadet is assuming a new identity as a future officer in the U.S. Army, and he is being indoctrinated with the norms of military life, where incentives—medals, ranks, camaraderie—are not financial-based. Current economics, however, can't explain how a cadet's new identity, and his commitment to ideals like duty and honor, will change his preferences and behavior. Identity economics emphasizes a cadet's identification with the military, and civilian employees' identification with their workplace.

"In each case," Akerlof and Kranton write, "identity would be a component of the workers' utility," and an organization's success depends on employees who share its goals. "Without identity," Kranton says, "you will miss a huge part of what drives economic outcomes and economic behavior." Akerlof adds, "The field is heading in this direction because these ideas answer questions that don't have good answers without them."

Akerlof and Kranton's work has stirred criticism. Some economists question whether identity is an empirically valid concept; others are doubtful that identity can be modeled effectively. But they have prominent supporters, like Amartya Sen, a professor of economics and philosophy at Harvard University and the author of Identity and Violence: The Illusion of Destiny (W.W. Norton, 2006). "Our priorities, obligations, and concerns are strongly influenced by our identities," Sen says. "This fact doesn't come through sufficiently in standard economic reasoning, so George and Rachel's remarkable work supplements standard economics in a very significant way."