CHAPTER 5: ADVANCED LINEAR PROGRAMMING APPLICATIONS

BA 424 l MANAGEMENT SCIENCE

The logic of a DEA model is to determine whether a

FOUR NEW APPLICATIONS OF LINEAR PROGRAMMING hypothetical composite facility can achieve the same or more
1. DATA ENVELOPMENT ANALYSIS output while requiring less input. If more output with less
2. REVENUE MANAGEMENT input can be achieved, the facility being evaluated is judged
3. PORTFOLIO MODELS AND ASSET ALLOCATION to be relatively inefficient.
4. GAME THEORY
The objective function in a DEA model is always Min E. The
facility being evaluated (County Hospital in this example) can
DATA ENVELOPMENT ANALYSIS (DEA)
be judged relatively inefficient if the optimal solution
provides E less than 1, indicating that the composite facility
- an application of linear programming used to measure
requires less in input resources.
the relative efficiency of operating units with the same
goals and objectives.
- Example: used within individual fast-food outlets in SUMMARY OF THE DEA APPROACH
the same chain
- To use DEA to measure the relative efficiency of
- Goal: to identify the inefficient outlets that should be
County Hospital, we used a linear programming model
targeted for further study and, if necessary, corrective
to construct a hypothetical composite hospital based
action.
on the outputs and inputs for the four hospitals in the
- measured the relative efficiencies of hospitals, banks,
problem.
courts, schools, and so on.
- The approach to solving other types of problems using
- performance of each institution or organization was
DEA is similar.
measured relative to the performance of all operating
- For each operating unit that we want to measure the
units in the same system
efficiency of, we must formulate and solve a linear
programming model similar to the linear program we
The operating units of most organizations have…
solved to measure the relative efficiency of County
multiple inputs: staff size, salaries, hours of operation, and
Hospital. The following step-by-step procedure should
advertising budget
help you in formulating a linear programming model
multiple outputs: profit, market share, and growth rate.
for other types of DEA applications. Note that the
- It is often difficult for a manager to determine which
operating unit that we want to measure the relative
operating units are inefficient in converting their
efficiency of is referred to as the jth operating unit.
multiple inputs into multiple outputs.
- This particular area is where data envelopment
Step 1. Define decision variables or weights (one for each
analysis has proven to be a helpful managerial tool.
operating unit) that can be used to determine the inputs
and outputs for the composite operating unit.
OVERVIEW OF THE DEA APPROACH Step 2. Write a constraint that requires the weights to sum
to 1.
Hypothetical composite - based on the outputs and
Step 3. For each output measure, write a constraint that
inputs for all operating units with the same goals.
requires the output for the composite operating unit to be
greater than or equal to the corresponding output for the
Constraints in the linear programming model require all
jth operating unit.
outputs for the composite hospital ≥ outputs of County
Step 4. Define a decision variable, E, which determines the
Hospital (the hospital being evaluated).
fraction of the jth operating unit’s input available to the
composite operating unit.
If the inputs for the composite unit < inputs for County Step 5. For each input measure, write a constraint that
Hospital, the composite hospital is shown to have the requires the input for the composite operating unit to be
same, or more, output for less input. less than or equal to the resources available to the
composite operating unit.
Example: In this case, the model shows that the composite Step 6. Write the objective function as Min E.
hospital is more efficient than County Hospital. Therefore,
the hospital being evaluated is less efficient than the
composite hospital. Because the composite hospital is
based on all four hospitals, the hospital being evaluated
can be judged relatively inefficient when compared to the
other hospitals in the group.
NOTES AND COMMENTS
1. Goal of DEA: to identify operating units that are
relatively inefficient. The method does not necessarily
identify the operating units that are relatively
efficient. Just because the efficiency index is E=1, we
cannot conclude that the unit being analyzed is
relatively efficient. Indeed, any unit that has the
largest output on any one of the output measures
cannot be judged relatively inefficient.
2. It is possible for DEA to show all but one unit to be
relatively inefficient. Such would be the case if a unit
producing the most of every output also consumes the
least of every input. Such cases are extremely rare in
practice.
3. In applying DEA to problems involving a large group of
operating units, practitioners have found that roughly
50% of the operating units can be identified as
inefficient. Comparing each relatively inefficient unit
to the units contributing to the composite unit may be
helpful in understanding how the operation of each
relatively inefficient unit can be improved.
REVENUE MANAGEMENT
- involves managing the short-term demand for a fixed
perishable inventory in order to maximize the revenue
potential for an organization.
- The methodology, originally developed for American
Airlines, was first used to determine how many airline
flight seats to sell at an early reservation discount fare
and how many airline flight seats to sell at a full fare.
- All major airlines use some form of revenue
management.
- often include pricing strategies, overbooking policies,
short-term supply decisions, and the management of
nonperishable assets.
- Application areas: hotels, apartment rentals, car
rentals, cruise lines, and golf courses.
- The development of a revenue management system
can be expensive and time consuming, but the
potential payoffs may be substantial.
Dual values - tell reservation agents the additional revenue
associated with overbooking each ODIF.
PORTFOLIO MODELS AND ASSET ALLOCATION
- Asset allocation - process of determining how to
allocate investment funds across a variety of asset
classes such as stocks, bonds, mutual funds, real
estate, and cash.
- Portfolio models - used to determine the percentage
of the investment funds that should be made in each
asset class.
- Goal: to create a portfolio that provides the best
balance between risk and return.
Linear programming models can be developed to
determine an optimal portfolio involving a mix of mutual
funds.
1st model: designed for conservative investors who are
strongly averse to risk.
2nd model: designed for investors with a variety of risk
tolerances.
In 1952 Harry Markowitz showed how to develop a portfolio
that optimized the trade-off between risk and return. His
work earned him a share of the 1990 Nobel Prize in
Economics.
A Portfolio of Mutual Funds
- A variety of measures can be used to indicate risk, but
for portfolios of financial assets all are related to
variability in return.
Conservative Portfolio
- In portfolio models, risk is minimized by diversification.
- To develop a portfolio that provides the best return
possible with a minimum risk, we need to maximize the
minimum return for the portfolio. Thus, the objective
function is simple: Max M
- Objective: to maximize the value of the minimum
return scenario.
Because the linear programming model was designed to
maximize the minimum return over all the scenarios
considered, we refer to it as the maximin model.
Moderate Risk Portfolio
- Different objective: is needed for this portfolio
optimization problem. A common approach is to
maximize the expected value of the return for the
portfolio.
NOTES AND COMMENTS
1. In this formulation, unlike in the previous max- imin
model, we keep the variables R1, R2, R3, R4, R5 in the
model. The variables R1, R2, R3, R4, and R5 defined in
constraints (5.2)–(5.6) are often called definitional
variables (a variable that is de- fined in terms of other
variables). These variables could be substituted out of
the formulation, result- ing in a smaller model.
However, we believe that when formulating a model,
clarity is of utmost im- portance and definitional
variables often make the model easier to read and
understand. Furthermore, stating the model as we
have eliminates the need for the user to do the
arithmetic calculations necessary to simplify the
model. These calculations can lead to error and are
best left to the software.
2. Most optimization codes have preprocessing routines
that will eliminate and substitute out the definitional
variables in constraints (5.2)–(5.6). Indeed, the
optimization model actually solved by the solver may
 differ considerably from the actual model formulation.
This is why we recommend the user focus on clarity
when model building.
3. When building a model such as (5.1)–(5.13) in Excel, we
recommend defining adjustable cells for only
investment variables, that is, FS, IB, LG, LV, SG, and SV.
There will be cells with formulas that calculate the
returns given in (5.2)–(5.6), but they need not be
adjustable. The Excel Solver model should have only
six adjustable cells. See the Excel Web file Moderate
Risk that illustrates this point.
ASSET ALLOCATION AND VARIABLE ANNUITIES
- Insurance companies use portfolio models for asset
allocation to structure a portfolio for their clients who
purchase variable annuities.
Variable annuity - an insurance contract that involves an
accumulation phase and a distribution phase.
In the accumulation phase the individual either makes a
lump sum contribution or contributes to the annuity over a
period of time.
In the distribution phase the investor receives payments
either in a lump sum or over a period of time. It usually
occurs at retirement, but because a variable annuity is an
insurance product, a benefit is paid to a beneficiary should
the annuitant die before or during the distribution period.
- Most insurance companies selling variable annuities
offer their clients the benefit of an asset allocation
model to help them decide how to allocate their
investment among a family of mutual funds.
- Usually the client fills out a questionnaire to assess his
or her level of risk tolerance. Then, given that risk
tolerance, the insurance company’s asset allocation
model recommends how the client’s investment should
be allocated over a family of mutual funds.
GAME THEORY
- two or more decision makers, called players, compete
against each other.
- Each player selects one of several strategies without
knowing in advance the strategy selected by the other
player or players.
- The combination of the competing strategies provides
the value of the game to the players.
- Its applications have been developed for situations in
which the competing players are teams, companies,
political candidates, and contract bidders.
Two-person, zero-sum games
Two-person - two players participate in the game.
Zero-sum - gain (or loss) for one player is equal to the loss
(or gain) for the other player.
As a result, the gain and loss balance out (resulting in a
zero-sum) for the game. What one player wins, the other
player loses.
The player seeking to maximize the value of the game selects
a maximin strategy.
The logic of game theory assumes that each player has
the same information and will select a strategy that
provides the best possible payoff from its point of view.
Example: After comparing the row minimum values,
Company A selects the strategy that provides the
maximum of the row minimum values. This is called a
maximin strategy. Thus, Company A selects strategy a1 as
its optimal strategy; an increase in market
share of at least 2% is guaranteed.
The player seeking to minimize the value of the game selects
a minimax strategy.
Example: After comparing the column maximum values,
Company B selects the strategy that provides the
minimum of the column maximum values. This is called a
minimax strategy. Thus, Company B selects b3 as its
optimal strategy. Company B has guaranteed that
Company A cannot gain more than 2% in market share.
IDENTIFYING A PURE STRATEGY SOLUTION
The game has…
Pure strategy solution
- if it is optimal for both players to select one strategy
and stay with that strategy regardless of what the
other player does
- maximum of the row minimums = the minimum of the
column maximums, the players cannot improve their
payoff by changing to a different strategy. The game is
said to have a saddle point/equilibrium point.
Thus, a pure strategy is the optimal strategy for the
players. The requirement for a pure strategy solution is as
follows:
Analyze a two-person, zero- sum game by first checking to
see whether a pure strategy solution exists.
- If a pure strategy solution exists, it is the optimal
solution to the game.
- If maximum of the row minimums ≠ minimum of the
column maximums, a pure strategy solution does not
exist.
IDENTIFYING A MIXED STRATEGY SOLUTION
Mixed Strategy Solution
Example: If maximum of the row minimums ≠ minimum of
the column maximums, it is not optimal for each company
to be predictable and select a pure strategy regardless of
what the other company does. The optimal solution is for
both players to adopt a mixed strategy.
Mixed strategy
- each player selects its strategy according to a
probability distribution.
- each company will use its probability distribution to
randomly select one of its three strategies.
The expected value, computed by multiplying each payoff by
its probability and summing, can be interpreted as a long-run
average payoff for a mixed strategy.
The player seeking to maximize the value of the game
selects a maximin strategy by maximizing the minimum
expected gain.
The player seeking to minimize the value of the game
selects a minimax strategy by minimizing the maximum
expected loss.a
With a mixed strategy game, only solve the linear program
for one of the players. Provided the value of the game is
greater than zero, the absolute value of the dual values
provides the optimal mixed strategy solution for the other
player.
- when a two-person, zero-sum game has a mixed
strategy, we only need to solve the linear program for
one of the players. The optimal mixed strategy for the
other player can be found by using the absolute value
of the dual values.
- Negative GAINA and LOSSB would causes the linear
program to have an infeasible solution.
So, If the value of a mixed strategy game may be negative,
this procedure will guarantee that the linear program used to
determine the optimal mixed strategy will have a feasible
solution.
- If this condition exists or may exist, the following
strategy can be used to modify the game and ensure
that the linear program has a feasible solution. Define
a constant c as follows:
- c = the absolute value of the largest negative payoff
for player A
- A revised payoff table can be created by adding c to
each payoff, turning it into an equivalent two-person,
zero-sum game. Because the revised payoff table
contains no negative payoffs, the nonnegativity
constraint for the value of the game will be satisfied
and a feasible solution will exist for the linear program.
- The optimal mixed strategy using the revised
payoffs will be the same as the optimal mixed
strategy for the original game. By subtracting c
from the optimal objective function value for the
game with the revised payoffs, you will obtain the
objective function value for the original game.
-
NOTES AND COMMENTS
1. The analysis of a two-person, zero-sum game be- gins
with checking to see whether a pure strategy solution
exists. If the maximum of the row minimums for player
A, VA, is not equal to the minimum the column
maximums for player B, VB, a pure strategy solution
does not exist. At this point, we can also conclude that
a mixed strategy solution is optimal and that the value
of the game will be between VA and VB. For example,
in our mixed strategy market-share game, the
maximum of the row minimums was 2% and the
minimum of the column maximums was 4%. Thus, we
can conclude that a mixed strategy solution exists and
that the value of the game is between 2% and 4%. We
would know this result before solving the mixed
strategy linear program.
If the maximum of the row minimums, VA, is positive
and the minimum of the column maxi- mums, VB, is
positive, we know that the value of the mixed strategy
game will be positive. In this case, it is not necessary to
revise the payoff table by the constant c to obtain a
feasible linear programming solution. However, if one
or both VA and VB are negative, the value of the mixed
strategy game can be negative. In this case, it is
desirable to revise the payoff table by adding the
constant c to all payoffs prior to solving the linear
program.
2. The linear programming formulation presented in this
section used nonnegativity constraints GAINA 0 and
LOSSB 0 so that the two-person, mixed strategy game
could be solved with traditional linear programming
software. If you are using software such as LINGO or
Excel, these variables do not have to be nonnegative.
In this case, eliminate the nonnegative requirements
and make GAINA and LOSSB unrestricted in sign. This
treatment guarantees that the linear program will have
a feasible solution and eliminates the need to add a
constant to the payoffs in situations where GAINA and
LOSSB may be negative.
SUMMARY
In this chapter we presented selected advanced linear
programming applications. In particular, we applied linear
programming to evaluating the performance of hospitals,
maximizing revenue for airlines, constructing mutual fund
portfolios, and competing for market share. In practice,
most of the modeling effort in these types of linear
programming applications involves clearly understanding
the problem, stating the problem mathematically, and then
finding reliable data in the format required by the model.
GLOSSARY

Data envelopment analysis (DEA) - A linear programming

application used to measure the relative efficiency of
operating units with the same goals and objectives.

Hypothetical composite - A weighted average of outputs

and inputs of all operating units with similar goals.

Efficiency index - Percentage of an individual operating

unit’s resources that are available to the composite
operating unit.

Game theory - A decision-making situation in which two or

more decision-makers compete by each selecting one of
several strategies. The combination of the competing
strategies provides the value of the game to the players.

Two-person, zero-sum game - A game with two players in

which the gain to one player is equal to the loss to the
other player.

Maximin strategy - A strategy where the player seeking to

maximize the value of the game selects the strategy that
maximizes the minimum payoff obtainable by the other
player.

Minimax strategy - A strategy where the player seeking to

minimize the value of the game selects the strategy that
minimizes the maximum payoff obtainable by the other
player.

Pure strategy - When one of the available strategies is

optimal and the player always selects this strategy
regardless of the strategy selected by the other player.

Saddle point - A condition that exists when pure strategies

are optimal for both players. Neither player can improve
the value of the game by changing from the optimal pure
strategy.

Mixed strategy - When a player randomly selects its

strategy based on a probability distribution. The strategy
selected can vary each time the game is played.

Expected value - In a mixed strategy game, a value

computed by multiplying each payoff by its probability and
summing. It can be interpreted as the long-run average
payoff for the mixed strategy.