A basic rule of economic analysis is: "look at the incentives!"  Economists assume people are motivated by self-interest, or at last they behave as if they were motivated by self-interest.  Most of the time this is a pretty reasonable assumption.  It leads to to engage in "thought experiments" where we imagine some self-interested invidual pursues his or her own best interests in the context of some defined set of incentives.

We can even explain some altruistic behavior as motivated by self-interest, if the altruist derives some sort of psychic benefit from his or her altruism.  (Some theorists distinguish this kind of altruism from "pure" altruism which does not benefit the altruist in any way, but I doubt you could distinguish these empirically.)  We are clearly evolved to take care of children, for instance, since natural selection logically rids the gene pool of bad parenting genes.

Comparative Advantage

Okay, here's a thought experiment, presented as a little cave-man fairy-tale.  Suppose there are two cave-people, Yob and Ugh, who spend their days gathering seeds to eat or hunting animals for skins to wear.  Let's say Yob can gather either 4 pounds of seeds or 6 skins in a typical day, while Ugh can gather either 2 pound of seeds or 4 skins in a typical day.  Since Yob is more productive in either activity, she has the absolute advantage in both seeds and skins.  But consider each cave-person's opportunity cost of producing skins.  Opportunity cost is simply the value of the best foregone alternative.  Here, if Yob spends a day hunting for skins, she forgoes seed-gathering for that day.  Specifically, to get 6 skins, she forgoes 4 pounds of seeds: Yob's opportunity cost of each skin is 2/3 pound of seeds, and her opportunity cost of a pound of seeds is 1.5 skins.  Ugh faces a similar seeds-or-skins choice: to get 4 skins, he forgoes 2 pound of seeds: Ugh's opportunity cost of each skin is 1/2 pound of seeds, and his opportunity cost of a pound of seeds is 2 skins.
 

Note here that even though Yob has the absolute advantage in both seeds and skins, Ugh has a comparative advantage in skins, because he has has the lower opportunity cost and forgoes less seeds to get each skin.  Conversely, Yob has a lower opporunity cost, and thus a comparative advantage, for seeds.  A pound of seeds costs Yob only only 1.5 skins forgone; for Ugh, a pound of seeds means forgoing 2 skins.  Each person has a comparative advantage in the activity where their opportunity cost is lowest.

Okay, it's a stupid story so far, but the differing comparative advantages give Yob and Ugh with some possible incentives to cooperate.  Let's suppose Yob and Ugh meet each other in the jungle, Yob has seeds and Ugh has skins, and Yob is chilly and Ugh is hungry.  So Yob says (in caveman language) "Gimme some skins" and Ugh says "Gimme some seeds," and they engage in barter.

Yob knows a skin is worth 2/3 pound of seeds if she gets it herself, so she's willing to trade anything up to 2/3 pound of seeds for each of Yob's skins.  Getting a skin only costs Ugh 1/2 pound of seeds, so he's willing to trade a skin for anything over 1/2 pound of seeds.  So let's say they settle on a "price" of 3/5 pound of seeds per skin, Yob gets Ugh's skins and warms up, and Ugh gets Yob's seeds at a "price" of 5/3 skins per pound and has lunch.

Since by definition each has a different comparative advantage, it's mutually beneficial for Yob and Ugh to specialize in the activity where they have the comparative advantage, and then barter.  If Yob specializes in seeds and Ugh in skins, their combined output is 4 pounds of seeds and 4 skins in a day.  If they work in isolation, each splitting their time evenly between seeds and skins,Yob produces 2 pounds of seeds and 3 skins, and Ugh produces 1 pound of seeds and 2 skin, so their combined output is 3 pounds of seeds and 5 skins per day.  The extra skin they get from not specializing is worth less to either of them than the extra pound of seeds they can get by specializing.

So Yob and Ugh both have clear incentives to specialize in the activities where they have comparative advantage, and barter for mutual benefit.  Having specialized in seeds, Yob could trade 2 pounds of seeds for 3.5 skins, so she would have 2 pounds of seeds and 3.5 skins--half a skin more for her day's work than she could get on her own.  And Ugh would have 2 pounds of seeds from Yob plus half a skin--more than he could get on his own in a day.

Yob and Ugh now comprise a little 2-person 2-good economy, with specialization that exploits their comparative advantages. This cooperative economy generates a measurable economic surplus (in this example, one less pound of seeds but one extra skin, which is worth more) to be shared between the particpants.  The moral of the story is pretty clear: Yob and Ugh can have a better standard of living if they specialize and barter than if they live and work in isolation.  Their dumber relatives may prefer to knock each other on the heads and just take each other's stuff rather than barter for it, but over time, those who don't specialize and cooperate are less well nourished, less well clothed, and less likely to survive and reproduce.  Over the millennia, natural selection favors economic cooperation.  This is pretty much how "Homo economicus" evolved.

Social groups all have customs or institutions that establish and guarantee the property rights of individual members, families, etc.  In fact, mutually-recognized property rights are a necessary precondition for economic exchange.  We will discuss property rights systems in detail in a subsequent lecture.

Money

Well, over the millennia, Yob's and Ugh's descendents kept specializing and bartering, and thrived and multiplied.  After a while, this proto-economy had lots of cave-people, each with a distinct comparative advantage, and lots of different goods and services.  As this economy diversifies, barter becomes more difficult because each party in any barter exchange must have what the other wants.  Urk, who makes the best nose rings in the village and barters nose rings for dinner each day, is having increasing difficulty finding new people who both have food to trade and still lack nose rings.  There is still plenty of demand for his nose rings, but the people who want nose rings are offering tattoos, pet wombats and other stuff that Urk doesn't need, and the people with food all have lots of nose rings already.  Urk could barter nose rings for pet wombats and then try to swap these for food, but this takes even more time and effort and Urk is hungry.  Lots of other people with specialized skills are having similar problems.

The natural solution to the inefficiency of barter is money.  Let's suppose Urk finds some shiny pebbles, and convinces people to accept the pebbles as payment for the food and other items he wants.  Urk says each pebble is worth a nose ring, complete with free nose piercing to be done by Urk himself with his very own sharp stick.  Urk finds it is easier to trade with pebbles than nose rings because the pebbles are much more transferable between people.  Somebody with food who already has a nose ring will trade her food for a pebble in the expectation that she can then trade the pebble to someone else who wants another nose ring.  As people start exchanging pebbles for other goods and services in this proto-economy, the relative values of all the goods and services can be indexed by the number of pebbles it takes to obtain a unit of anything else.  A nose ring costs one pebble, dinner costs two pebbles, a pet wombat costs six pebbles, etc.  The pebbles are money.

Money performs several functions: it is a medium of exchange, facilitating the flows of goods and services in the economy by freeing people from the constraints of barter.  It is a scale of value, since the values of all goods and services are now priced in money units.  And money serves as a store of value, since people can sell things in one time period, keep the money for a while knowing that it holds its value well, and then buy something with the money sometime later.

It doesn't really matter what people use for currency--gold, pebbles, seashells--as long as everybody trusts in the convertibility of money to whatever goods and services they desire.  The people on the island of Yap supposedly use huge boulders on the beach as money; since the boulders aren't portable, people just exchange titles to boulders (I am not making this up).  Europeans adopted gold as money.  Gold has a few decorative and industrial uses that made it initially acceptable as money, it doesn't degrade over time, and its value (purchasing power) per ounce was high because it has always been relatively scarce.

Banking

In Europe, gold remained the principal form of money into the Middle Ages.  People accumulated gold as wealth, and other people coveted it, so hoarding gold involved risk of burglary, and travelers often got held up by bandits.  Goldsmiths naturally handled lots of gold, and typically had the most secure vaults in which to store it, so other villagers naturally took to depositing their gold for safety in the goldsmith's vault.  The goldsmith would give them written receipts for their gold, and maybe charge them a nominal storage fee.  Depositors could redeem their receipts for the specified quantities of gold at any time.  Once the gold goes in the vault, it no longer matters who owns which specific bags or bars, since any ounce of gold is as good as any other.

Since it was inconvenient to go to the goldsmith's to withdraw a some of your gold every time you wanted to buy something in the village, or deposit gold after every sale, the villagers simply started accepting deposit receipts in payment for goods and services.  Since the title to deposited gold was automatically transferred to whoever had the receipt for it, the gold could stay in the goldsmith's vault; people just signed over the receipts the goldsmith had issued instead.  These receipts function as money because everyone trusts that they are redeemable for gold, and gold can be exchanged for anything else.

Naturally some people would occasionally run short of money, and would visit the goldsmith to ask for a loan.  The goldsmith would agree to loan out some of the gold desposited in his vault for a small interest charge, knowing that it was highly unlikely all his depositors would present their receipts all at once and demand all their gold back.  In fact, the goldsmith wouldn't loan out actual gold; he could just have the borrower sign a promissory note and then write him another deposit receipt!

Now the goldsmith has become a primitive bank, taking deposits, making loans and earning interest on the loans.  In fact, the goldsmith can issue loan receipts for a substantial portion of the gold deposits for which he has already issued original deposit receipts.  So now, thanks to the goldsmith's little lending scam, there are duplicate receipts circulating in the village for a lot of the deposited gold.  The goldsmith has increased the money supply in the village.  The money supply is the sum of the issued receipts, not just the sum of the gold deposits.  Is this a problem?  Not as long as all the villagers remain confident they can redeem their receipts for gold at any time; they keep on using the receipts as money and leave the gold in the vault.  The goldsmith needs to keep enough gold on hand to be certain he can supply any customers who do redeem their receipts.  It's only a problem if public confidence in the goldsmith collapses, there's a "run on the bank" as everybody tries to redeem their receipts for gold at once, the gold deposits run out and the goldsmith gets tarrred, feathered and run out of town.