Real Price Change: Understanding Inflation and Escalation – Video 4

Welcome to the fourth video in our series: Understanding Inflation and Escalation in Defense Acquisition: A Guide for Better Public Understanding. Today we will present in detail how real price change affects Department of Defense cost estimates and how to approximate real price change. Let’s begin. If you recall, escalation contains two components: inflation and real price change. In the last video we discussed inflation and began to introduce the other component real price change. As discussed the 120 billion dollar estimate reflects a realistic cost estimate for the Columbia Class program and the expected amount of dollars that will leave the Treasury. The 100 billion dollar estimate reflects the one hundred twenty eight billion dollar estimate without the effects of inflation over the program’s acquisition period but continues to expose the effects of real price change. In other words, escalation incorporates both the effects of inflation and the real price change. Another way to see how escalation incorporates inflation and real price change is to represent it in graphical form. To start, recall that all programs have a base cost, essentially what it would cost to buy each unit of the program if the cost never changed over time. On top of the base costs, the program is affected by escalation. Notice how the cumulative effects of escalation on the Columbia Class program are a combination of inflation and real price change. That is because real price change is calculated from a combination of escalation and inflation over a period of time. Now let’s go over a simplified example of the role that real price change plays and price changes over time. Let’s take three favorite goods in the market: apples, computers, and submarines. At the end of year one each product has an actual observable price. To keep it simple, let’s say an apple costs one dollar, a computer costs one hundred dollars, and well, an inexpensive submarine costs one thousand dollars. Let us assume that we are provided the economy’s inflation rate from an authoritative source. Suppose a 3 percent inflation rate in year two. Because the purchasing power of the dollar decreased 3 percent in year two, it is forecasted that the prices of all goods and services in the economy will rise 3 percent. Note that these price changes are assumed, not observed; however, actual market conditions vary for each good and service respectively, and the observed prices in year two as affected by escalation may not match to the forecasted prices according to the change in the purchasing power of the dollar. Notice how the observed price of the computer in year two has actually decreased, and the observed price for the apple matches the price forecasted by inflation. The difference between the forecasted price changes due to the change in the purchasing power of the dollar which is represented by inflation, and the observed price changes which is represented by escalation approximates the real price change. For the apple, the observed price change was 3 percent while the forecasted effects of inflation were also 3 percent. Because the effects of escalation and inflation matched, the real price change for the apple is 0 percent. For the computer, escalation was negative 5 percent. The forecasted effects of inflation were positive 3 percent. The difference between inflation and escalation approximates a real price change of negative 8 percent. For our inexpensive submarine escalation was positive 7 percent and the forecasted effects of inflation were also positive 3 percent. Because escalation was greater than inflation, the real price change is approximately positive 4 percent. Thank you for watching. This concludes video four in our series, Understanding Inflation and Escalation in Defense Acquisition: A Guide for Better Public Understanding. For more information or additional resources on how inflation and escalation are used in defense acquisition, please visit our website at CADE.OSD.MIL/INFLATION.

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