From Hydrogenaudio Knowledgebase
Summarized from wikipedia
Psychoacoustics is the study of subjective human perception of sounds. Alternatively it can be described as the study of psychology of acoustical perception.
It can explain how a sharp clap of the hands might seem painfully loud in a quiet library, but is hardly noticeable after a car backfires on a busy, urban street.
 Psychoacoustic Model
The psychoacoustic model provides for high quality lossy signal compression by describing which parts of a given digital audio signal can be removed (or aggressively compressed) safely - that is, without significant losses in the quality of the sound.
Psychoacoustic analysis routinely leads to compressed music files that are 10 to 12 times smaller than high quality original masters with very little discernible loss in quality. Such compression is a feature of nearly all modern audio codecs.
Psychoacoustic models are based heavily on human anatomy, especially the ear's limitations in perceiving sound as outlined previously. To summarize, these limitations are:
- High frequency limit
- Absolute threshold of hearing
- Absolute threshold of pain
- Temporal masking
- Simultaneous masking
Given that the ear will not be at peak perceptive capacity when dealing with these limitations, a compression algorithm can assign a lower priority to sounds outside the range of human hearing. By carefully shifting bits away from the unimportant components and toward the important ones, the algorithm ensures that the sounds a listener can hear most clearly are of the highest quality.