Behavioral Economics, Financial Literacy, and Consumers’ Financial Decisions

Abstract

This chapter reviews research in behavioral economics and financial literacy that raises concerns that consumers lack competence to make complex financial decisions. Consumers do not collect comprehensive information or extensively evaluate alternatives. They rely on heuristics that cause them to make systematic errors in judgment, and many individuals lack an understanding of basic financial principles, which arguably would hamper individuals’ ability to manage their finances effectively. Decisions are generally purposive, however, and individuals tend to be deliberative and thoughtful when the situation warrants. Outcomes may not be optimal but such decision processes nevertheless may be an economical means for achieving desired goals. The extent to which these phenomena impair actual decisions in markets is not at all clear. At this time, neither existing behavioral evidence nor conventional economic evidence supports a general conclusion that consumers’ financial decisions are not rational or that markets do not work reasonably well.