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The Young Economist

From the Magazine: Friday, November 17, 2006

Credit: Steve Peixotto
Economics often presumes that people act rationally. Ulrike Malmendier knows better.

If Ulrike Malmendier were rational, she wouldn’t have so many degrees. “My problem is whatever I’m working on right now I think is the most important topic in the world,” she says. “I’m totally absorbed.”

It’s a puzzle she knows well. Malmendier’s wandering path through law, economics, and psychology, from Bonn to Boston to Berkeley, earning six university diplomas in the space of seven years, has made her a leader in the field of behavioral economics. She is an authority on the gap between our most rational courses of action and the things we actually do.

It would have been much easier to pick a traditional economics topic, rather than looking into the mess of human irrationality. “Back in Germany, at least at the time when I studied, the people who were able to do very advanced economics, very technical and mathematical stuff, would not at all connect to real-world problems,” says Malmendier, who now teaches economics at the University of California at Berkeley. “There was just a big gap.”

She was drawn across the Atlantic to Harvard, where economists are more open to thinking about human psychology. Studying there—and ultimately earning a second doctorate—turned her view of economics upside down.

“The people at Harvard were motivated by what was happening out there in the economy. How are markets functioning? How do people make decisions? I woke up and realized there are all these super-interesting questions we can answer,” she says. “It really made me much more interested in economics.”

"How are markets functioning? How do people make decisions? I woke up and realized there are all these super-interesting questions we can answer."

At the core of behavioral economics—a field that has become popular over the last ten years or so—is the study of how people’s biases, errors, and nonrational behavior affect their decision-making. Those decisions range from how high an eBay user is willing to bid for a trinket (we will overpay, it turns out, for the thrill of winning an auction) to whether one multimillion-dollar corporation will acquire another.

“Emotions get in the way. People are tempted. They’re overconfident. They’re underconfident. We used to think we can neglect that. But now we think, well, it happens sort of systematically,” says Malmendier. “And as soon as it’s systematic, we economists have to take it seriously because it affects the design of products, of advertising, of contracts, and purchasing decisions.”

“Paying Not to Go to the Gym,” a recent paper, won her public attention. Of the thousands of health club members Malmendier studied, most chose to subscribe on a monthly basis rather than paying for each visit. But 85 percent of those who chose a monthly contract didn’t attend the gym enough to justify the cost. “It seems that people,when they enroll in the gyms, are systematically overestimating how often they are going to attend in the future,” says Malmendier. The health club industry has known about this pattern for years, she explains, but it is only recently that economists and their models have caught up.

Health clubs are a natural topic for Malmendier. Thirty-three years old, athletic, and outgoing, she is often taken for a student on campus. She is pleasantly surprised by how little discrimination she has faced. “I think it’s probably very different from even ten years ago. There are a few women who are now senior professors and they tell me stories of what they had to fight and I really realize that it’s changed a lot—probably thanks to them.”

Malmendier has extended her method well beyond the weight room—notably, into the boardroom. In her paper “Who Makes Acquisitions? CEO Overconfidence and the Market’s Reaction,” she asked why so many corporate CEOs, in making acquisitions, “overpay for target companies and undertake value-destroying mergers.” The study looked at simple overconfidence, especially when companies have abundant internal funding, as the answer.

“If you’re CEO of a top company, you’ve had a lot of success in your life...otherwise you wouldn’t be there. So maybe you tend to overestimate that everything you touch turns to gold,” says Malmendier. “They just truly believe it’s a good merger, and it’s not surprising that they do, given that everything else went so well in the past.”

David Laibson, Malmendier’s adviser at Harvard, calls her “one of the most brilliant and productive researchers in the business.” He says she may spur a bidding war among top schools—a kind of irrationality Malmendier might want to encourage.

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