Camm 4e Ch14 PPT

Business Analytics
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Nonlinear Optimization
Models
Chapter 14
Introduction
• Nonlinear optimization problem: Any optimization problem in which at
least one term in the objective function or a constraint is nonlinear;
referred to as what-if models.
• Examine a production problem in which the objective function is a
nonlinear function of the decision variables.
• Present a nonlinear model for facility location.
• Present the Nobel Prize-winning Markowitz model for managing the
trade-off between risk and return in the construction of an investment
portfolio.
• Discuss a well-known model that effectively forecasts sales or adoptions
of a new product.
A Production Application:
Par, Inc. Revisited
An Unconstrained Problem
A Constrained Problem
Solving Nonlinear Optimization Models Using Excel Solver
Sensitivity Analysis and Shadow Prices in Nonlinear Models
A Production Application: Par, Inc. Revisited
(Slide 1 of 17)
An Unconstrained Problem:
• Par, Inc. has decided to move into the market for standard and deluxe
golf bags; Par’s distributor has agreed to buy all the golf bags Par
produces over the next three months.
• We introduce constrained and unconstrained nonlinear optimization
problems by considering an extension of the Par, Inc. linear program.
• Consider the case in which the relationship between price and quantity
sold causes the objective function to be nonlinear; the result is an
unconstrained nonlinear program.
(Slide 2 of 17)
An Unconstrained Problem (cont.):
• In formulating the linear programming model for the Par, Inc. problem,
we assumed that the company could sell all of the standard and deluxe
bags it could produce; depending on the price of the golf bags, this
assumption may not hold.
• An inverse relationship usually exists between price and demand: as price
increases, the quantity demanded decreases.
• Let PS denote the price Par, Inc. charges for each standard bag and PD
denotes the price for each deluxe bag.
(Slide 3 of 17)
• Assume that the demand for standard bags, S, and the demand for
deluxe bags, D, are given by:
S  2,250  15PS
D  1,500  5PD
• The cost to produce a standard bag is $70 and the cost to produce each
deluxe golf bag is $150.
(Slide 4 of 17)
• We get the total profit contribution as the sum of the profit contribution
for Standard bags and the profit contribution for Deluxe bags and it is
given as:
 1  2 1 2
Total profit contribution  80 S    S  150D    D
 15  5
• This function is an example of a quadratic function because the
nonlinear terms have an exponent of 2 (S 2 and D2 ).
• Quadratic function: It is a nonlinear function with term to the power of two.
(Slide 5 of 17)
Figure 14.1: The Par, Inc. Feasible
Region and the Optimal Solution
for the Unconstrained
Optimization Problem
(Slide 6 of 17)
• Using Excel Solver, we find that the values of S and D that maximize the
profit contribution function are S = 600 and D = 375.
• The corresponding prices are $110 for standard bags and $225 for deluxe
bags, and the profit contribution is $52,125.
• The feasible region for the unconstrained optimal solution point (600,
375), is shown in Figure 14.1.
• The unconstrained optimum of (600, 375) is obviously outside the
feasible region.
(Slide 7 of 17)
A Constrained Problem:
• In calculating the unconstrained optimal solution, we have ignored the
production constraints.
• Par, Inc. has limited amounts of time available in each of four departments
(cutting and dyeing, sewing, finishing, and inspection and packaging).
(Slide 8 of 17)
A Constrained Problem (cont.):
• The complete mathematical model for the Par, Inc. constrained nonlinear maximization
problem:
(Slide 9 of 17)
A Constrained Problem (cont.):
• The solution to this new constrained nonlinear maximization problem is
shown in Figure 14.2.
• We see three profit contribution contour lines—each point on the same
contour line is a point of equal profit.
• The contour lines show profit contributions of $45,000, $49,920.55, and
$51,500.
• The profit contours are ellipses.
(Slide 10 of 17)
Figure 14.2: The Par, Inc. Feasible
Region with Objective Function
Contour Lines
(Slide 11 of 17)
Solving Nonlinear Optimization Models Using Excel Solver:
• We use the constrained nonlinear Par, Inc. problem to illustrate how to
use Excel Solver to solve nonlinear optimization problems.
• Figure 14.3 shows the Excel model and Solver dialog box for the
nonlinear Par, Inc. problem.
• The SUMPRODUCT function is used in cells B19 through B22 to calculate
the number of hours required in each department.
(Slide 12 of 17)
Figure 14.3: Spreadsheet Model
and Solver Parameters Dialog Box
for the Nonlinear Par, Inc. Problem
(Slide 13 of 17)
Solving Nonlinear Optimization Models Using Excel Solver (cont.):
• The price function for standard bags is entered in cell B25 as
 150   1 15   $B$14 and similarly for deluxe bags in cell D26 as
 300   1 5   $C$14.
• The objective function in cell B16 contains the formula

  B25  B9   B14+  B26  C9   C14, which corresponds to
 150   1 15 S  70  S   300   1 5 D  150  D.
(Slide 14 of 17)
Sensitivity Analysis and Shadow Prices in Nonlinear Models:
• There are two sections: one for the variables and the other for
constraints:
• The variables section gives the cell location, name, final (optimal) value, and
reduced gradient for each variable.
• Reduced gradient is the value associated with a variable in a nonlinear
model that is analogous to the reduced cost in a linear model; the shadow
price of a binding simple lower or upper bound on the decision variable.
• The constraint section gives the cell location, name, and final value for the
left-hand side of each constraint; the far-right column gives the Lagrangian
multiplier for each constraint.
(Slide 15 of 17)
Sensitivity Analysis and Shadow Prices in Nonlinear Models (cont.):
• Lagrangian multiplier is the shadow price for a constraint in a nonlinear
problem, that is, the rate of change of the objective function with respect
to the right-hand side of a constraint.
• For the Par, Inc. example, as we increase the number of hours available in
the cutting and dyeing department, we expect the profit to increase by
$26.72 per hour.
• Notice that no ranges are given for allowable right-hand side changes;
this is because the allowable increase and decrease are essentially zero.
(Slide 16 of 17)
Figure 14.4: Excel Solver
Sensitivity Report for the
Nonlinear Par, Inc. Problem
(Slide 17 of 17)
Sensitivity Analysis and Shadow Prices in Nonlinear Models (cont.):
• Changing the right-hand side of a binding constraint by even a small
amount will change the value of Lagrangian multiplier.
• The Lagrangian multiplier does give an estimate of the importance of
relieving a binding constraint.
Local and Global Optima
Overcoming Local Optima with Excel Solver
Local and Global Optima (Slide 1 of 16)
• Local optima: A feasible solution when there are no other feasible
solutions with a better objective function value in the immediate
neighborhood; may be either a local maximum or a local minimum.
• Local maximum: A feasible solution when there are no other feasible
solutions with a larger objective function value in the immediate
neighborhood.
• Local minimum: A feasible solution when there are no other feasible
solutions with a smaller objective function value in the immediate
neighborhood.
• Global optimum: A feasible solution when there are no other
feasible points with a better objective function value in the entire
feasible region; may be either a global maximum or a global
minimum.
• Global maximum: A feasible solution when there are no other
feasible points with a larger objective function value in the entire
feasible region; also a local maximum.
• Global minimum: A feasible solution when there are no other feasible
points with a smaller objective function value in the entire feasible
region; also a local minimum.
• Concave function: A function that is bowl-shaped down.
• For example, the following are concave functions:
f  x   5 x 2  5 x
f  x , y    x 2  11y 2
Consider the function f  X , Y    X 2  Y 2 ; the shape of this function is

illustrated in Figure 14.5.
Figure 14.5: A Concave Function f  X , Y    X 2  Y 2
• The maximum value for this particular function is 0, and the point
(0, 0) gives the optimal value of 0.
• The point (0, 0) is a local maximum; it is also a global maximum
because no point gives a larger function value.
• In general, if all the squared terms in a quadratic function have a
negative coefficient and there are no cross-product terms, such as
xy, the function is a concave quadratic function.
• For the Par, Inc. problem, we are assured that the local maximum
identified by Excel Solver in Figure 14.3 is the global maximum.
• Convex function: A function that is bowl-shaped up.
• For example, the following are convex functions:
f  x   x 2  5x
f  x , y   x 2  5y 2
Consider the function f  X , Y   X 2  Y 2 ; the shape of this function is

illustrated in Figure 14.6.
Figure 14.6: A Convex Function f  X , Y   X 2  Y 2
• Figure 14.6 is bowl-shaped up and called a convex function.
• The minimum value for this particular function is 0, and the point
(0, 0) gives the minimum value of 0.
• The point (0, 0) is a local minimum and a global minimum because
no values of X and Y give an objective function value less than 0.
• For a convex function, we know that if our computer software finds
a local minimum, it has found a global minimum.
Overcoming Local Optima with Excel Solver:
• Some nonlinear functions have multiple local optima. For example:
Max f  X ,Y   X sin  5 X   Y sin  5 Y 
s.t.
0  X  1, 0 Y 1
• Where sin is the trigonometric sine function.
•  is approximately 3.1416.
• The hills and valleys in the graph in Figure 14.7 show that this function
has a number of local maximums and local minimums.
Figure 14.7: A Function with
Local Maxima and Minima
Overcoming Local Optima with Excel Solver (cont.):
• Table 14.1 shows the results returned from Excel Solver for different
starting points (values in the decision variable cells when Solver is
invoked).
• In each of the five cases in Table 14.1, Solver returns with the message,
“Solver has converged to the current solution. All constraints are
satisfied.”
Table 14.1: Solutions from Excel Solver for a Problem with Multiple
Local Optima
Starting Point Solution Returned
Objective Function
X Y X Y Value
0.000 0.000 0.129 0.129 0.231
1.000 0.000 0.905 0.000 0.902
0.000 1.000 0.000 0.905 0.902
0.500 0.500 0.508 0.508 1.008
1.000 1.000 0.905 0.905 1.805
• Excel Solver does provide an option that allows you to increase the
confidence that you have found a global optimal solution.
• Clicking Options on the Solver Parameters dialog box and then selecting
the GRG Nonlinear tab results in the Options dialog box.
Figure 14.8: The GRG Nonlinear
Tab in Solver Options
• Clicking the Use Multistart option causes Solver to use multiple starting
solutions and report the best solution found from all of the starting
points.
• The Population Size is the number of starting points used.
• Solver selects starting points randomly using the Random Seed (an
integer value) such that the points are within the bounds specified.
• Although providing simple lower and upper bounds is not required
(unless the Bounds on Variables option is selected), the procedure is
much more effective when bounds are provided.
• Recommend selecting the Require Bounds on the Variables checkbox
and providing bounds before you use the Multistart option.
• In the Options dialog box, randomly generated starting points will be
used and simple bounds of 0 and 1 have been specified as constraints in
the Solver dialog box.
• The result reported by Solver is X = 0.90447, Y = 0.90447, with objective
function = 1.804.
• The message provided by Solver is “Solver converged in probability to a
global solution.”
A Location Problem
A Location Problem (Slide 1 of 6)
• The case of LaRosa Machine Shop (LMS):
• LMS is studying where to locate its tool bin facility on the shop floor.
• In an attempt to be fair to the workers in each of the production
stations, management has decided to try to find the position of the
tool bin that would minimize the sum of the distances from the tool
bin to the five production stations.
• We define the following decision variables:
• X = horizontal location of the tool bin.
• Y = vertical location of the tool bin.
• The locations of the five production stations appear in Figure 14.9.
Figure 14.9: Data for the LMS Tool
Bin Location Problem
• We may measure the distance from a station to the tool bin located
at (X, Y) by using Euclidean (straight-line) distance.
• For example, the distance from fabrication located at the
coordinates (1, 4) to the tool bin located at the coordinates (X, Y) is
given by:
 X  1   Y  4 
2 2
• The unconstrained optimization problem is as follows:
Figure 14.10: Solution to the LMS
Tool Bin Location Problem
• Note that we do not require that the variables X or Y be
nonnegative.
• The optimal solution found by Excel Solver is X = 2.230, Y = 3.349.
• Location models are used for determining the optimal locations for:
• Drilling holes in computer circuit boards.
• Locating distribution centers and retail stores in supply chains.
• A variety of different location models can be created by using
different objective functions or by adding additional constraints on
distances traveled.
Markowitz Portfolio Model
Markowitz Portfolio Model (Slide 1 of 12)
• Markowitz mean-variance portfolio: A portfolio optimization model
used to construct a portfolio that minimizes risk subject to a
constraint requiring a minimum level of return.
• A key trade-off in financial planning is that between risk and return;
for a chance to earn greater returns, the investor must also accept
greater risk.
• In most portfolio optimization models:
• The return used is the expected (or average) return of the possible
outcomes.
• The risk is some measure of variability in these possible outcomes.
Illustration: Hauck Investment Services:
• Hauck Investment Services designs annuities, IRAs, 401(k) plans, and
other investment vehicles for investors with a variety of risk
tolerances.
• Hauck would like to develop a portfolio model that can be used to
determine an optimal portfolio involving a mix of six mutual funds.
• Table 14.2 shows the annual return (%) for five 1-year periods for
the six mutual funds.
Table 14.2: Mutual Fund Performances in Five Selected Years (Used as
Planning Scenarios for the Next 12 Months)
Year 1 Annual Year 2 Annual Year 3 Annual Year 4 Annual Year 5 Annual
Mutual Fund Return (%) Return (%) Return (%) Return (%) Return (%)
Foreign Stock 10.06 13.12 13.47 45.42 −21.93
Intermediate-Term
Bond 17.64 3.25 7.51 −1.33 7.36
Large-Cap Growth 32.41 18.71 33.28 41.46 −23.26
Large-Cap Value 32.36 20.61 12.93 7.06 −5.37
Small-Cap Growth 33.44 19.40 3.85 58.68 −9.02
Small-Cap Value 24.56 25.32 −6.70 5.43 17.31
• The following decision variables:
• FS = Proportion of portfolio invested in the foreign stock mutual fund.
• IB = Proportion of portfolio invested in the intermediate-term bond fund.
• LG = Proportion of portfolio invested in the large-cap growth fund.
• LV = Proportion of portfolio invested in the large-cap value fund.
• SG = Proportion of portfolio invested in the small-cap growth fund.
• SV = Proportion of portfolio invested in the small-cap value fund.
FS  IB  LG  LV  SG  SV  1
Let R1 denote the portfolio return if the scenario represented by year 1 occurs.
Let R2 denote the portfolio return if the scenario represented by year 2 occurs.
If pS is the probability of scenarios, among n possible scenarios, then the expected
return for the portfolio is R , where:
n
R   psRs
s 1
• If we assume that the five planning scenarios in the Hauck Financial
Services model are equally likely to occur:
5 5
R   1 Rs  1  Rs
s 1
5 5 s 1
• The measure of risk most often associated with the Markowitz

portfolio model is the variance of the portfolio’s return:
n
Var   ps  Rs  R 
2
s 1
• For the Hauck Financial Services example, the five planning scenarios are
equally likely, thus: 5
Var   1  Rs  R 
2
s 1
5
• Assume that Hauck clients would like to construct a portfolio from the six
mutual funds listed in Table 14.2 that will minimize their risk as measured
by the portfolio variance.
• The complete Markowitz model involves 12 variables and 8 constraints
(excluding the nonnegativity constraints):
5
  R
2
Min 1 R
5 s 1
S
• The objective for the Markowitz model is to minimize portfolio variance.
• The solution for this model using a required return of at least 10%
appears in Figure 14.11.
Figure 14.11: Solution
for the Hauck Minimum
Variance Portfolio with
a Required Return of At
Least 10%
• The minimum value for the portfolio variance is 27.136.
• This solution implies that the clients will get an expected return of
10% and minimize their risk as measured by portfolio variance by
investing approximately:
• 16% of the portfolio in the foreign stock fund (FS = 0.158).
• 53% in the intermediate bond fund (IB = 0.525).
• 4% in the large-cap growth fund (LG = 0.042).
• 27% in the small-cap value fund (SV = 0.274).
• Figure 14.12 is a graph of the minimum portfolio variances versus
required expected returns as required expected return is varied
from 8% to 12% in increments of 1%.
• This graph is called the efficient frontier; each point on the efficient
frontier is the minimum possible risk for the given return.
• By looking at the graph, investors can select the mean-variance
combination with which they are most comfortable.
Figure 14.12: An Efficient Frontier for the Markowitz Portfolio Model
Forecasting Adoption of a New
Product
Forecasting Adoption of a New Product
(Slide 1 of 14)
• Forecasting new adoptions after a product introduction is an
important marketing problem.
• Frank Bass developed a forecasting model:
• Nonlinear optimization is used to estimate the parameters of the Bass
forecasting model.
• The model has three parameters that must be estimated.
(Slide 2 of 14)
m = the number of people estimated to eventually adopt the new
product.
q = the coefficient of imitation.
p = the coefficient of innovation.
Let Ct 1 denote the number of people who have adopted the product
through time t  1.
m  Ct 1 is the number of potential adopters remaining at time t  1.
(Slide 3 of 14)
We refer to the time interval between time t  1 and time t as time
period t.
The likelihood of adoption is p  q  Ct 1 m  .
The likelihood of adoption due to innovation is simply p, the
coefficient of innovation.
The likelihood of adoption due to imitation is q  Ct 1 m  .
(Slide 4 of 14)
Ft , the forecast of the number of new adopters during time period t , is:
Ftt   p  q  C 1 m   m  Ct 1 
In developing a forecast of new adoptions in period t using the Bass model,

the value of Ct 1 will be known from past sales data.
(Slide 5 of 14)
Figure 14.13: Weekly Box Office Revenues for an Independent Studio
Film and a Summer Blockbuster Movie
(Slide 6 of 14)
• Figure 14.13 shows the graph of box office revenues (in $ millions)
for two different films, an independent studio film and a summer
blockbuster action movie, over the first 12 weeks after release.
• Strictly speaking, box office revenues for time period t are not the
same as the number of adopters during time period t.
• However, the number of repeat customers is usually small, and box
office revenues are a multiple of the number of moviegoers.
• The Bass forecasting model seems appropriate here.
(Slide 7 of 14)
• It is common statistical practice to estimate the parameters p, q, and
m by minimizing the sum of squared errors.
• Doing so for the Bass forecasting model leads to the following
nonlinear optimization problem:
(Slide 8 of 14)
Table 14.3: Box Office Revenues
and Cumulative Revenues in $
Millions for Independent Studio
Film
The data in Table 14.3 provide

the revenue and cumulative
revenues for the independent
studio film in weeks 1 to 12.
(Slide 9 of 14)
The nonlinear model to estimate
the parameters of the Bass
forecasting model for the
independent studio film is:
(Slide 10 of 14)
The solutions to this nonlinear model and to a similar nonlinear model
for the summer blockbuster are given in Table 14.4.
Table 14.4: Optimal Forecast Parameters for Independent Studio Film
and Summer Blockbuster Movie
Parameter Independent Studio Film Summer Blockbuster

p 0.074 0.460
q 0.490 −0.018
m 34.850 149.540
(Slide 11 of 14)
• For the independent studio film, which has the largest revenues in week 4, the
value of the imitation parameter q is 0.49.
• This value is substantially larger than the innovation parameter p = 0.074.
• The film picks up momentum over time due to favorable word of mouth.
• After week 4, revenues decline as more and more of the potential market for
the film has already seen it.
• Contrast these data with the summer blockbuster movie, which has a negative
value of –0.018 for the imitation parameter q and an innovation parameter p of
0.49.
• The greatest number of adoptions is in week 1, and new adoptions decline
afterward; obviously, the word-of-mouth influence is not favorable.
(Slide 12 of 14)
Figure 14.14: Forecast and Actual Weekly Box Office Revenues for
Independent Studio Film and Summer Blockbuster
(Slide 13 of 14)
• The Bass forecasting model does a good job of tracking revenue for
the independent small-studio film.
• For the summer blockbuster, the Bass model does an outstanding
job; it is virtually impossible to distinguish the forecast line from the
actual adoption line.
• One way to use the Bass forecasting model for a new product is to
assume that sales of the new product will behave in a way that is
similar to a previous product for which p and q have been calculated
and to subjectively estimate m, the potential market for the new
product.
(Slide 14 of 14)
• Example: Assume that box office receipts for movies next summer will
behave similarly to box office receipts for movies last summer—then the p
and q used for next summer’s movies would be the p and q values
calculated from the actual box office receipts last summer.
• A second approach is to wait until several periods of data for the new
product are available.
• Example: If five periods of data are available, the sales data for these five
periods could be used to forecast demand for period 6; then, after six
periods of sales are observed, a forecast for period 7 is made.
• This method is often called a rolling-horizon approach.
End of Chapter 14

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Business Analytics

• The objective function in cell B16 contains the formula

Consider the function f  X , Y    X 2  Y 2 ; the shape of this function is

Consider the function f  X , Y   X 2  Y 2 ; the shape of this function is

• The unconstrained optimization problem is as follows:

• The measure of risk most often associated with the Markowitz

In developing a forecast of new adoptions in period t using the Bass model,

The data in Table 14.3 provide

Parameter Independent Studio Film Summer Blockbuster

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