Household finance

The market can provide commitment devices and other mechanisms to help people overcome these biases, but it can also exacerbate them. In general, the market will have weak or missing incentives for resolving these problems when borrowers are naïve about their biases or underestimate their lack of understanding. Moreover, organizations may deliberately misinform or underinform their customers about the terms of the contracts they are signing. The consequences of these biases can be profound for people in poverty, or on the edge of poverty, because they lack a margin for error. And because countries may not have the institutional capacity and the safety nets to safeguard individuals against financial losses, poor people need to be even more attentive to financial decisions (Mullainathan and Shafir 2009). Poverty also heightens uncertainty about future costs and benefits of different actions, magnifying the individual’s focus on the pressing and current scarcity of resources—and further complicating decision making for individuals who are often overwhelmed with numerous important day-to-day decisions (see chapter 4). Given these considerations, providing an appropriate institutional setting—that is, access to wellfunctioning financial markets and a sound regulatory environment—may not be enough to improve people’s decisions. In developing countries, more proactive policies may be necessary to address the behavioral constraints on financial decision making. For example, providing access to a new insurance instrument may not be sufficient to induce people to use it if they perceive the product as ambiguous or do not trust the institution issuing it. This chapter suggests ways that policy makers can make institutions more responsive to the behavioral factors driving people’s financial decisions. This Financial decisions are difficult. They typically involve great uncertainty about the future, whether about future income, cash (liquidity) needs, or interest rates. Much has been learned in recent years about how individuals actually make these decisions. More often than not, financial decision making is influenced by impulsive judgments, emotions, temptation, loss aversion, and procrastination. The research discussed in chapter 1 revealed systematic biases in decision making: that is, systematic departures from what individuals intend to do and say that they want to do and what they actually do. All these biases apply particularly to financial decision