inventory level yk1, we will be better off raising the inventory level up to yk2, since Gk(yk2) + K < Gk(yk1).

Similarly, if the first part of (iii) fails to hold, it may be the case that Gk(yk) < Gk(Sk) + K.

Proof. Parts (i ) and (i i ) follow easily from the continuity of Gk (yk ) and the infiniteness of Gk(yk) as |y| → ∞.
Note that if there exist multiple numbers sk, we choose the largest one.

ToseethatGk(yk)isnonincreasingforyk ≤sk,wesupposethat,tothecontrary, k0k0

G (yk) has a local maximum at y . Without loss of generality, assume G (y ) ≥ Gk(sk). Then there must exist
some positive number ρ > 0 so that Gk(y0) − Gk(y0−ρ)≥0.Letx􏰄y0,a+x􏰄a+y0 􏰄Sk andx−b􏰄y0−ρ.First assume
that Gk(y0) > Gk(sk). The K-convexity of Gk(yk) implies that

kk00k0k0
K +G (Sk)−G (y )−((Sk −y )/ρ)(G (y )−G (y −ρ)) ≥ 0,

which, together with K + Gk(Sk) 􏰄 Gk(sk), contradicts the hypothesis. Now assume that Gk (y 0 ) 􏰄 Gk (sk );
again, the K -convexity will not hold unless Gk (y 0 − ρ) 􏰄 Gk(sk). This proves the first part of (iii).

We now show that there are no two points yk1 and yk2 such that Sk < yk1 < yk2 and Gk(yk1)−Gk(yk2) > K. Again,
assume that, to the contrary, such points exist. Letx􏰄yk1,x−b􏰄Sk andx+a􏰄yk2.TheK-convexityofGk(yk)gives

K +Gk(y )−Gk(y k2

k1

)−((y −y )/(y −S ))(Gk(y )−Gk(S )) ≥ 0, k2 k1 k1 k k1 k

which again contradicts the hypothesis, since Gk(yk1) ≥ Gk(Sk).

Finally, it follows from (ii) that Gk(yk1) − Gk(yk2) ≤ K for sk < yk1 ≤ yk2.
Theabovelemmacanbeinterpretedasfollows.Foryk ∈(−∞,sk),Gk(yk)≥

Gk(sk) and is nonincreasing; for yk ∈ (sk, Sk], Gk(yk) − Gk(Sk) < K; and finally, foryk >Sk,Gk(yk)−Gk(yk
+a)≤Kforanya≥0.

The next result follows directly from the above two lemmas.

Corollary 11.3.5 If Gk(y) satisfies the conditions specified in the above two lem- mas, then the optimal
inventory policy solving (11.3) is an (sk , Sk ) policy for all k, k 􏰄 1,2,...,m.

Thus, the optimality of (sk , Sk ) policy in period k implies that K+Gk(Sk) ifyk ≤sk,
zk(y )􏰄

k
Gk(yk) ifyk >sk. It now remains to show that Gk(yk) is indeed K-convex.

Lemma 11.3.6 The function Gk(y) is K-convex for all k, k 􏰄 1, . . . , m.

(11.4)

Proof. We start by stating two properties of K-convex functions, whose proof follows directly from the
definition of K-convexity. See, for instance, Dreyfus and Law (1977), Bertsekas (1987) or Exercise 11.6.

11.3 Finite Horizon Models 185

186 11. Stochastic Inventory Models

1. If g1(y) and g2(y) are K-convex and L-convex, respectively, then for α, β ≥ 0, αg1(y) + βg2(y) is (αK + βL)-
convex.

2. If g(y) is K-convex, then ED[g(y − D)] is also K-convex.

We prove the lemma in two steps. In the first step we show that if the (sk−1, Sk−1) policy is optimal in period k −
1 and Gk−1(y) is K-convex, then Gk(y) is also K- convex. In the second step, we demonstrate that G1(y) is K-
convex. By Lemmas 11.3.2, 11.3.3 and 11.3.4, these two steps are sufficient to show that Gk(y) is K -convex.

Consider Step 1. The definition of Gk(y),

Gk(y) 􏰄 G(y) + ED[zk−1(y − D)],

together with the two properties stated above implies that it suffices to show that zk−1(y) is K-convex. Our
objective is to prove that

k−1 k−1 a k−1 k−1

K+z (x+a)−z (x)− (z (x)−z (x−b))≥0

for any a,b ≥ 0 and for all x ∈ (−∞,∞). For this purpose, and following the treatment in Dreyfus and Law (1977),
we differentiate between four cases, depending upon where x, x + a and x − b lie.

Case 1: x − b > sk−1. Clearly, x, x + a > sk−1. By (11.4), zk−1(x) 􏰄 Gk−1(x) and hence, zk−1(x) is K-convex in this
region.
Case2:x−b≤sk−1 <x.From(11.4),

k−1

k−1

a k−1

k−1 k−1 k−1

K+z
􏰄 K +G

(x +a)−z

􏰄 K +G

.
􏰄 W.

k−1 k−1

b k−1

k−1

(x)− (x)−

ba

[G [G

(x)−G (x)−G

k−1 k−1

(Sk−1)−K] (sk−1)]

(x)− (x +a)−G (x +a)−G

[z

(x)−z

(x −b)]

To see that zk−1(x) is K-convex in this region, we further consider two subcases: (2.1) Gk−1(x) ≤ Gk−1(sk−1) and
(2.2) Gk−1(x) > Gk−1(sk−1). In (2.1), W ≥ 0 because of Lemma 11.3.4 (iii) and the K-convexity of Gk−1(x). For
(2.2), consider

k−1 k−1 a k−1 k−1 ′

K+G (x+a)−G (x)−

x − sk−1

[G (x)−G (s

k−1

.
)]􏰄 W .
Because Gk−1(x) is K-convex, W′ ≥ 0. By the assumption x − b ≤ sk−1 < x, weseethatb≥x−sk−1.Hence,0≤W′ ≤W
andzk−1(x)isK-convexinthis interval.
Case3:x≤sk−1 <x+a.Inthiscase,

(x −b)]

k−1
􏰄 Gk−1(x + a) − Gk−1(Sk−1) ≥ 0,

K +z

(x +a)−z

k−1

(x)−

[z (x)−z
a k−1 k−1

where the last inequality holds since Sk−1 is a minimizer of Gk−1(y). Case 4: x + a ≤ sk−1. In this case,

zk−1(x) 􏰄 zk−1(x + a) 􏰄 zk−1(x − b) 􏰄 K + Gk−1(Sk−1), and therefore, zk−1(y) is obviously K-convex.

As for Step 2, the proof is straightforward. In the final period,

G1(y ) 􏰄 G(y ), (11.5) 11

where the function G(·) is defined in equation (11.2). Since G(y1) is convex in y1, G1(y ) is thus K-convex. In
addition, G(y) → ∞ as |y| → ∞. Hence, the (s , S )

111 policy is optimal for the final period. The proof is now completed.

We now show how to solve the dynamic programming problem, that is, how to compute the optimal (sk,Sk)
policy for every k ≥ 1. We start computing the optimal policy for the final period, and then recursively calculate
the functions Gk(y) and zk(y). These functions are used to determine the optimal (sk,Sk) for k 􏰄 2,...,m.

We know that the functions G1(y) and z1(y) as well as the optimal (s1, S1) can be found as described in Section
11.2. Given the functions Gj (y) and zj (y) and the optimal (sj,Sj), for j 􏰄 1,2,...,k − 1, we determine the functions
Gk(y) and zk(y). As in the single period model, let

Gko(yk) 􏰄 K + Gk(Sk).

That is, Gko(yk) is the expected cost given that we start in period m − k + 1 with on-hand inventory of yk units,
order up to Sk in that period, and act optimally in the remaining k − 1 periods.

Clearly, the optimal Sk will be the value of y that minimizes Gk (y). Alternatively, to compute the optimal Sk we
find the point at which the function Gko(yk), a line with slope 0, is tangent to Gk(yk) + K.

To determine sk , we look for y smaller than Sk such that Gk(y) 􏰄 K + Gk(Sk).

We thus conclude that

0 if y ≤ sk,
z′k(y) 􏰄 (11.6) G′k(y) if y > sk.

What can we say about the relationship between the different quantities (sk , Sk ), k 􏰄 1,2,...,m? Very little! The
only result known was obtained by Iglehart (1963a).

Theorem 11.3.7 The optimal policy solving (11.3) satisfies S1 ≤ Sk , 2 ≤ k ≤ m. Proof. It is sufficient to show
that G′k(y) ≤ 0 for all y < S1. Suppose that we

choose the smallest S

that minimizes G(y ). The convexity of G1 (y )(􏰄 G(y ))

11.3 Finite Horizon Models 187

188 11. Stochastic Inventory Models

implies that G′1(y) < 0 for all y < S1, and hence z′1(y) ≤ 0 for all y < S1; see equation (11.6). Now assume z′k(y) ≤
0 for all y < S1 and observe that

11.4 Quasiconvex Loss Functions

The above proof on the optimality of (sk , Sk ) policies relies on the fact that the one- period loss function G(y) is
convex. In many practical situations this assumption is not appropriate. For instance, consider the previous
model, but assume that whenever a shortage occurs, an emergency shipment is requested. Suppose further, that
this emergency shipment incurs a fixed cost plus a linear cost proportional to the shortage level. It can be easily
shown that the new loss function G(y) is, in general, not convex.

To overcome this difficulty, Veinott (1966) offers a different yet elegant proof for the optimality of (sk , Sk )
policies under the assumption that −G(y ) is unimodal or G(y) is quasiconvex. Here we provide a slightly
simplified proof suggested by Chen (1996) for the model considered here.

Definition 11.4.1 A function f is quasiconvex on a convex set X if for any x and y ∈ X and 0 ≤ q ≤ 1,

f(qx +(1−q)y) ≤ max{f(x),f(y)}.

It is easily verified that a convex function is also quasiconvex. An alternative

G′k+1(y) 􏰄 G′(y) + which completes the proof.

z′k(y − D)dF(D) < 0,

definition may be as follows: f is said to be quasiconvex if −f (x) is unimodal.

Consider the following m-period model:

zk(yk) 􏰄 min{Kδ(y − yk) + Gk(y)}

y ≥yk
where

Gk(y) 􏰄 G(y)+ED[zk−1(y −D)], for k 􏰄 1,2,...,m. In the analysis below we use the following assumptions on
G(y).

(i) G(y) is continuous and quasiconvex. (ii) G(y)>infxG(x)+Kas|y|→∞.

(11.7)

(11.8)