19 March 2014

Why are costs subjective? And what is the subjective value of money?

A student asks me:

A classmate and I are having some trouble with the question in homework 2 about costs being subjective.  
One answer focuses on individual preferences as the source of costs:
"Costs are subjective because value is determined by the importance that individual players place on goods and services for the achievement of their desired ends. Everyone has different tastes and preferences and this can be reflected when determining how much they are willing to pay for a particular good or service." 
The other focuses on opportunity costs: 
"Costs are subjective because they are derived from marginal opportunity cost. The value of the next best alternative is a subjective value because it depends on the person who is considering a situations. Value is determined by the importance that individual players place on goods and services for the achievement of their desired ends. "

My answer:

The second answer is much better. Costs are subjective because they are opportunity costs - the cost is the value of the next best thing, and this value is subjective. Cost is not just how much you are paying for something, but it is what else you could have done with that money. (After all, the money itself is only valuable because of the things you can buy with it.)

The first answer is incorrect for the following reason:

Even if the two people value the item in the same way, the cost of acquiring the thing may still differ, because the value of the next best thing may differ. The first answer implies that if two people value something in the same way (say, they derive the same subjective pleasure from it), than they would be willing to pay the same amount for it. But this is incorrect. They may still differ in regard to how much they are willing to pay for it because the opportunity cost may differ.

By contrast, if the opportunity cost is the same, they are going to be willing to pay the same amount for the good, even if the subjective value of the good differs! For example, to simplify, suppose we have movie vouchers (we can only buy movies with these things). If I really like movie X, and you only kind of like it, but we both equally dislike the other movies playing, we are going to be wiling pay the same voucher amount to see X. The value of the voucher is given by our subjective valuation of the other movies, not by our subjective valuation of the movie we are buying.