People want to be happy, but happiness cannot be derived merely from economic prosperity. Economists, therefore, became more and more interested in other values that determine individuals’ well-being and thus affect their behavior. By now, research on subjective well-being has identified many factors that make for a good life beyond economic prosperity. Social psychology, thereby, proved helpful in highlighting the great importance of social identity on subjective well-being. Individuals develop a “sense of self”: a set of “self-images” that determines their identity. This personal identity depends on some purely individualistic “personal identity” and on a “social identity,” which depends crucially on the way an individual is embedded in social groups. A shared “social identity” emerges based on cognitive criteria, such as shared fate, situations, and attributes, which can be either positive or negative. Belonging to a group is important for the individual’s self-concept, as its norms, values, beliefs, and ideologies and one’s adherence or nonadherence to them affect one’s well-being.

George Akerlof and Rachel Kranton deserve credit for bringing these considerations to economic reasoning. They argue that identity strongly affects economic outcomes, and incorporating the concept of identity into an economic model of behavior thus allows a better understanding of many decisions that individuals make when interacting with others. For a variety of social and economic problems resulting from, for instance, interactions in the workplace or from social exclusion, they demonstrate how economic reasoning has to be altered when incorporating social identity. Identity, thereby, is not only a fixed determinant affecting well-being. Rather, it is in many circumstances a choice variable and choices of identity are among the most important economic decisions. Delimitation to this choice, for instance, in the case of involuntary unemployment, may act as a highly detrimental determinant of individual well-being.

For economic analysis, they divide the individual’s total utility function into distinct individualistic and identity parts. The individualistic part represents the standard utility that depends on both one’s own actions and the actions of others. It includes private consumption and leisure and depends on the provision of public goods and the consumption of goods by others that creates positive and negative externalities. The identity part of the utility function represents the utility derived from adhering to personally held objectives and beliefs and the ideals and social norms relevant to one’s own social category. Identity is affected by one’s own actions, but it is also shaped by the behavior, characteristics, and beliefs of others. This creates a new and important type of externality highly relevant for subjective well-being. Including identity when analyzing decision-making highlights that striving to behave according to the internal rules of one’s social group is a personal choice, but altering self-identity by changing social groups may be an alternative choice. When taking these new types of externalities into account, the assessment of public policies may lead to substantially different conclusions than standard economic analysis suggests. Bringing identity to economics has opened up many promising avenues of research into what makes a good life and how politics might affect the determinants of well-being in different ways than we previously thought.