Instructors Manual

Chapter 8

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Chapter 8
I

Chapter Outline

8.1.

Formulating a Management Problem as a Nonlinear Optimization Model

Discussion of an optimal portfolio management problem
Discussion of an optimal production and pricing problem
Discussion of a facility location problem

8.2.

Graphical Analysis of Nonlinear Optimization Models in Two Variables

Feasible region of a nonlinear optimization problem
Isoquant lines of a nonlinear problem
Local and global optimal solutions

8.3.

Computer Solution of Nonlinear Optimization Problems

8.4.

Shadow Prices Information in Nonlinear Optimization Problems

Lagrange multipliers and their interpretation as shadow prices

8.5.

A Closer Look at Portfolio Optimization

Extensions of the basic model
Efficient frontier

8.6.

Taxonomy of the Solvability of Nonlinear Optimization Problems

Convex minimization problems
Concave maximization problems
General nonlinear problems

II

Teaching Tips

1.

If you use Case 2 as an assignment, you may want to add a few hints concerning
the formulation of the constraints in this nonlinear model. Many students find this
case particularly hard without hints.

2.

You can complement the discussion on the portfolio problem by explaining how
to obtain the correlation matrix or the covariance matrix from Excel, based on
observations of the behavior of different stocks with respect to time.

3.

As with linear optimization models, you may want to stress the importance of
linear optimization models by presenting a practical application in industry (other
than the cases in this chapter). There are many management science journals with
such examples and the students always get a positive reinforcement in this subject
after hearing of a success story in linear optimization.

Manual to accompany Data, Models & Decisions: The Fundamentals of Management Science by Bertsimas and Freund. Copyright
2000, South-Western College Publishing. Prepared by Manuel Nunez, Chapman University.

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Chapter 8

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Answers to Chapter Exercises

8.1
(a) A nonlinear optimization model is similar to a linear optimization model in
the following:
Both have a feasible region determined by constraints
Both have an objective function that should be maximized or minimized
Both can be formulated as spreadsheet computer models
(b) The chief differences between a nonlinear optimization problem and a linear
optimization problem are:
The feasible region of a nonlinear optimization problem is not necessarily
determined by linear constraints, and so it is not necessarily a polyhedron
as in the linear optimization case
The objective function of a nonlinear optimization model is not
necessarily linear
Generally, nonlinear optimization problems are more difficult to solve on
the computer
The decision variables in a nonlinear optimization problem are not
necessarily continuous
In a nonlinear optimization problem there might be several local solutions
in addition to global solutions. In a linear optimization problem every
local solution is a global solution
(c) These differences make more difficult to solve a nonlinear optimization
problem. For instance, since an optimal solution of a nonlinear optimization
problem is not necessarily at corner points of the feasible region, it is more
difficult for the computer to search for this solution (it is easier to narrow the
search to corner points).
8.2

The plot of the objective function is shown in the following chart (the scale on the
x axis is 1:1000):
100
80

f(x)

60
40
20
0
-20 0

2000

4000

6000

8000

10000

The local minima are at x = 0.9455, x = 6.1385, and x = 10. The value of the
global minimum is x = 0.9455. The local maxima are at x = 0, x = 3.5795, and x =
9.5125. The value of the global maximum is x = 9.5125.
Manual to accompany Data, Models & Decisions: The Fundamentals of Management Science by Bertsimas and Freund. Copyright
2000, South-Western College Publishing. Prepared by Manuel Nunez, Chapman University.

Instructors Manual
8.3

Chapter 8

93

We solve the following nonlinear optimization problem:

Maximize
4(1 0.75t) + 1/(1 + t).
Subject to:
Non-negativity:
t >=0, t integer.
The graph of the objective function is shown below. Using Solver, we found that
the optimal solution is attained at t = 22 years with an optimal objective value of
$4.03 millions.
Revenue + Salvage Value
4.5

$ millions

4
3.5
3
2.5
2
1.5
1
0.5
0
0

10

20

30

Tim e

The plot of the objective function is shown in the following chart.

f(x)

8.4

30
25
20
15
10
5
0
0

10

The local minima are at x = 0, x = 4.255, and x = 8.545. The value of the global
minimum is x = 0. The local maxima are at x = 1.215, x = 7.605, and x = 10. The
value of the global maximum is x = 10.

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8.5
(a) If PF = 270, then DF = 490 270 = 220. If PC = 230, then DC = 640 2(230) =
180. Therefore, the demands agree with the linear model from the previous
chapter.
(b) The optimal strategy is to produce 151.8 full-size microwave ovens and 165.5
compact-size microwave ovens, setting the unit prices at $338.18 and
$237.27, respectively. The optimal contribution to earnings is $51,300, which
is greater than the optimal contribution for the linear model ($40,500). I would
recommend Magnetron to set the prices at this level and to study the results to
determine how accurate is the model or if the model needs to be revised.
8.6
(a) Let P and M be the decision variables defined in this case. We obtain the
following nonlinear optimization model:
Maximize
(506 0.75P)P + (653.5 M)M.
Subject to:
Fabric:
8.75P + 60.5M <= 40,000,
Cutting:
0.1P + 0.2M <= 150,
Sewing:
0.4P + 0.3M <= 500,
Pillow price:
506 0.75P >= 0,
Mattress cover price:
653.5 M >= 0,
Non-negativity:
P, M >= 0
(b) The optimal solution is to produce 337.3 pillows and 326.7 mattress covers,
with an optimal objective value of $192,111.
8.7

Required Expected
Return (%)

(a) The minimum standard deviation of the investors portfolio is 12.71%. The
optimal asset allocation is 12.6% in IBM, 21.4% in ATT, 4% in GM, and 62%
in GE.
(b) The maximum expected return of the investors portfolio is 20.7%. The
optimal asset allocation is 11.7% in IBM, 15% in ATT, 2.8% in GM, and
70.5% in GE.
(c) The efficient frontier based on the model from part (a) is shown in the
following chart.

23
21
19
17
15
12.5

13

13.5

14

Optimal Standard Deviation (%)

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8.8

Required Expected
Return (%)

(a) The minimum standard deviation of the investors portfolio is 14.3%. The
optimal asset allocation is 45% in XON, 25% in MSFT, 24% in ORCL, and
6% in SP500.
(b) The maximum expected return of the investors portfolio is 20.3%. The
optimal asset allocation is 28% in XON, 12.6% in MSFT, 10.4% in ORCL,
and 49% in SP500.
(c) The efficient frontier based on the model from part (a) is shown in the
following chart.

60
50
40
30
20
10
0
0

10

20

30

40

Optimal Standard Deviation (%)

8.9
(a) The expected profit if the projects are successful is given by EP = 1750p1 +
700p2 + 1300p3 + 800p4 + 1450p5 + 1300p6. The expected start-up cost is
given by ES = 325(1-p1) + 200(1-p2) + 490(1-p3) + 125(1-p4) + 710(1-p5) +
240(1-p6). Consider the following nonlinear optimization model.
Maximize
EP ES 150(x1 + + x6).
Subject to:
Engineers available:
x1 + + x6 <= 25,
Non-negativity:
x1, , x6 >= 0.
The optimal solution is x1 = 2.8, x2 = 1.2, x3 = 3, x4 = 1.5, x5 = 3.4, and x6 =
2.6.
(b) If a random variable X takes the value of A with probability p and the value B
with probability (1-p), then Var(X) = (A-B)2p(1-p). Using this formula, and
assuming that the success or not of one project is statistically independent of
the success or not of any other project, we obtain that the variance of the
contribution to profit is given by the following formula. In computing this
formula, notice that A takes values 1750, 700, , 1300, and B takes values
-325, -200, , -240.
VP = (1750 + 325)2p1(1-p1) + (700 + 200)2p2(1-p2) +
+ (1300 + 240)2p6(1-p6).
Therefore, we solve the following nonlinear optimization problem.

Manual to accompany Data, Models & Decisions: The Fundamentals of Management Science by Bertsimas and Freund. Copyright
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Minimize (VP).
Subject to:
Minimum contribution: EP ES 150(x1 + + x6) >= 1100,
Engineers available:
x1 + + x6 <= 25,
Non-negativity:
x1, , x6 >= 0.
The optimal solution is x1 = 5, x2 = 1.6, x3 = 4.2, x4 = 1.5, x5 = 6, and x6 = 3.
8.10

Consider the following nonlinear optimization model.

Maximize
d1 + d2 + d3 + d4.
Subject to:
Budget:
x1 + x2 + x3 + x4 <= 1,500,000,
TV Ads:
x1 + x2 >= 700,000,
More newspapers than radio: x4 >= 1.1x3,
Non-negativity:
x1, x2, x3, x4 >= 0.
The optimal solution is x1 = $388,905, x2 = $311,095, x3 = $43,805, x4 =
$756,195. The optimal demand is 11,400 units. The binding constraints are the
budget constraint and the at least $700,000 on TV ads.

8.11
(a) The optimal location is at x = 9.17 and y = 8.5.
(b) The optimal location is at x = 10 and y = 8.81.

IV

Answers to Chapter Cases

ENDURANCE INVESTORS
Part I
(a) Not shown.
(b) The optimal portfolio weights for next quarter are as follows:
BA
0.10712

XON
0.00000

GM
0.07776

MCD
0.22651

PG
0.28861

SP
0.30000

The expected annual return of the portfolio is 13.14%.

(c) The shadow prices (Lagrange Multipliers) are shown in the table below. The
binding constraints are those concerning the standard deviation of the
portfolio, the upper bound on the SP variable, and the lower bound on the
XON variable. The shadow price corresponding to the standard deviation of
the portfolio indicates that if we increase by a small amount the right-hand
side, then in the revised model the optimal expected annual return will
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increase by an amount proportional to 0.22%. If we increase by a small

amount the upper bound on the SP variable, then the optimal expected annual
return will increase by an amount proportional to 0.67%. Finally, if we
increase by a small amount the XON variable, then the optimal expected
annual return will decrease by an amount proportional to 1.2%.

Constraints
Cell

Name

$D$43
$D$44
$D$47
$D$48
$D$49
$D$50
$D$51
$D$52
$D$55
$D$56
$D$57
$D$58
$D$59
$D$60

FSUM
Standard Deviation
Max Single (BA)
Max Single (XON)
Max Single (GM)
Max Single (MCD)
Max Single (PG)
Max Single (SP)
Non-Negative (BA)
Non-Negative (XON)
Non-Negative (GM)
Non-Negative (MCD)
Non-Negative (PG)
Non-Negative (SP)

Final
Value
1.0000
13.000
0.1071
0.0000
0.0778
0.2265
0.2886
0.3000
0.1071
0.0000
0.0778
0.2265
0.2886
0.3000

Lagrange
Multiplier
10.0553
0.222
0.0000
0.0000
0.0000
0.0000
0.0000
0.6716
0.0000
-1.2468
0.0000
0.0000
0.0000
0.0000

(d) The efficient frontier of the portfolio is shown in the following chart.

Maximized Expected Annual

Return

Effient Frontier
13.4
13.2
13.0
12.8
12.6
12.4
12.2
12.0
11.8
10.0

12.0

14.0

Standard Deviation

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Part II
(e) The new objective function is as described in the case, accounting for the
transaction costs. We add the following constraints to limit the change in
decision variables:
|X1 0.21| <= 0.15,
|X2 0.16| <= 0.15,
|X3 0.21| <= 0.15,
|X4 0.09| <= 0.15,
|X5 0.09| <= 0.15,
|X6 0.24| <= 0.15.
The changes in the spreadsheet are not shown.
(f) The optimal portfolio weights for next quarter are as follows:
BA
0.21000

XON
0.01000

GM
0.06000

MCD
0.22365

PG
SP
0.24000 0.25636

The optimal expected annual return of the portfolio, after accounting for
transaction costs, is 12.78%. The optimal fractions did not change too much
with respect to the optimal fractions of the previous model, except for the
fraction corresponding to BA.
(g) The shadow prices (Lagrange Multipliers) are shown in the table below. All of
the constraints are not binding, except for the constraint corresponding to the
standard deviation and the constraints for the absolute difference
corresponding to XON, GM, and PG. The shadow prices indicate that the
optimal expected return of the portfolio can be increased if we increase the
upper bound on the standard deviation or the upper bounds on the difference
with respect to the original fractions assigned to variables XON, GM, and PG.
When comparing to the shadow prices from the previous model, we find that
the constraints corresponding to the 30% upper bound on the variables are not
binding, and hence unnecessary in the revised model.

Manual to accompany Data, Models & Decisions: The Fundamentals of Management Science by Bertsimas and Freund. Copyright
2000, South-Western College Publishing. Prepared by Manuel Nunez, Chapman University.

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Constraints
Cell
$D$47
$D$48
$D$51
$D$52
$D$53
$D$54
$D$55
$D$56
$D$59
$D$60
$D$61
$D$62
$D$63
$D$64
$D$66
$D$67
$D$68
$D$69
$D$70
$D$71

Final
Value

Name
FSUM
Standard Deviation
Max Single (BA)
Max Single (XON)
Max Single (GM)
Max Single (MCD)
Max Single (PG)
Max Single (SP)
Non-Negative (BA)
Non-Negative (XON)
Non-Negative (GM)
Non-Negative (MCD)
Non-Negative (PG)
Non-Negative (SP)
Absolute Difference (BA)
Absolute Difference (XON)
Absolute Difference (GM)
Absolute Difference (MCD)
Absolute Difference (PG)
Absolute Difference (SP)

1.0000
13.000
0.2100
0.0100
0.0600
0.2236
0.2400
0.2564
0.2100
0.0100
0.0600
0.2236
0.2400
0.2564
0.00000
0.15000
0.15000
0.13365
0.15000
0.01636

Lagrange
Multiplier
11.6682
0.086
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0.00000
1.67183
0.03465
0.00000
0.08343
0.00000

(h) The efficient frontier of the portfolio is shown in the following chart.

Maximized Expected Annual

Return

Efficient Frontier
12.8
12.6
12.4
12.2
12.0
11.8
11.6
10.0

12.0

14.0

Standard Deviation

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(i) The new efficient frontier is stiffer and takes lower values on the Y-axis than
the previous efficient frontier.
(j) I would recommend using the set of portfolio weights corresponding to the
revised model. This is because this set takes into consideration the two
additional conditions given by Brian in this model and because the efficient
frontier is more stable than the efficient frontier for the original model when
changing the standard deviation upper bound.

CAPACITY INVESTMENT, MARKETING AND PRODUCTION AT

ILG, INC.
(a) We use the following variables:
P1 = Year 1 production,
P2 = Year 2 production,
X1 = Year 1 investment ($),
X2 = Year 2 investment ($),
A1 = Year 1 amount spent in advertising ($),
A2 = Year 2 amount spent in advertising ($).
Using these variables, we obtain the following nonlinear optimization model.
Maximize
Subject to:
Year 1 investment:
Year 1 capacity:
Year 1 demand:
Year 2 investment:
Year 2 capacity:
Year 2 demand:
Non-negativity:

850P2.
A1 + X1 <= 2,000,000,
P1 <= X1/200 + (X1),
P1 <= 4,000 + A1/400,
A2 + X2 <= 800P1 + 2,000,000 A1 X1,
P2 <= 1.3(X2/200 + (X2)),
P2 <= 0.75(4,000 + A1/400) + A2/300,
P1, P2, X1, X2, A1, A2 >= 0.

The optimal solution is given by P1 = 6,344, P2 = 14,953, X1 = $1,062,559, X2

= $2,016,404, A1 = $937,441, and A2 = $3,058,478. The year 2 revenue
obtained by using this optimal solution is $12,709,733.
(b) The results are shown in the table below. The optimal strategy discussed in the
previous item does not significantly change as we change the percentage of
growth in capacity. In particular, first year variables stay the same and the
optimal objective value increases as the capacity growth rate increases.
Growth %
0.20
0.25
0.30
0.35

P1
6,344
6,344
6,344
6,344

P2
14,559
14,761
14,953
15,134

X1
$1,062,559
$1,062,559
$1,062,559
$1,062,559

X2
$2,134,375
$2,073,797
$2,016,404
$1,961,953

A1
$937,441
$937,441
$937,441
$937,441

A2
$2,940,506
$3,001,084
$3,058,478
$3,112,928

Objective
$12,375,481
$12,547,119
$12,709,733
$12,864,008

Manual to accompany Data, Models & Decisions: The Fundamentals of Management Science by Bertsimas and Freund. Copyright
2000, South-Western College Publishing. Prepared by Manuel Nunez, Chapman University.

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(c) As in the previous case, the optimal strategy previously discussed does not
significantly change as we change the percentage of reduction in demand. As
before, first year variables stay the same and the optimal objective value
increases as the demand reduction rate increases
Reduction %
0.60
0.65
0.70
0.75
0.80
0.85
0.90

P1
6,344
6,344
6,344
6,344
6,344
6,344
6,344

P2
14,309
14,524
14,738
14,953
15,167
15,381
15,596

X1
$1,062,559
$1,062,559
$1,062,559
$1,062,559
$1,062,559
$1,062,559
$1,062,559

X2
$1,923,989
$1,954,783
$1,985,588
$2,016,404
$2,047,230
$2,078,066
$2,108,913

A1
$937,441
$937,441
$937,441
$937,441
$937,441
$937,441
$937,441

A2
$3,150,892
$3,120,098
$3,089,293
$3,058,478
$3,027,651
$2,996,815
$2,965,969

Objective
$12,162,764
$12,345,118
$12,527,440
$12,709,733
$12,891,995
$13,074,229
$13,256,434

(d) My recommendation is to follow the optimal plan discussed in part (a).

During its first year, the plan is not affected by uncertainty in the rates of
capacity growth and demand reduction. In the second year, changes in these
rates only have a small effect in the plan. Therefore, it is a sound plan.

Manual to accompany Data, Models & Decisions: The Fundamentals of Management Science by Bertsimas and Freund. Copyright
2000, South-Western College Publishing. Prepared by Manuel Nunez, Chapman University.