Managerial economics linearprogramming

MANAGERIAL ECONOMICS
LINEAR PROGRAMMING

LINEAR PROGRAMMING
 a powerful technique that is often used by large
corporations, not-for-profit organizations, and
government agencies to analyze complex production,
commercial, financial, and other activities.
 a mathematical technique for solving constrained
maximization and minimization problems when there
are many constraints and the objective function to be
optimized, as well as the constraints faced, are linear
(i.e., can be represented by straight lines)

-developed by the Russian mathematician L.V. Kantorovich in 1939 and
extended by the American mathematicianG. B. Dantzig in 1947. Its
acceptance and usefulness have been greatly enhanced by the advent of
powerful computers, since the technique often requires vast calculations.

ASSUMPTIONS
 based on the assumption that the objective function that the
organization seeks to optimize (i.e., maximize or minimize), as
well as the constraints that it faces, are linear and can be
represented graphically by straight lines.This means that we
assume that input and output prices are constant, that we have
constant returns to scale, and that production can take place
with limited technologically fixed input combinations. Constant
input prices and constant returns to scale mean that average
and marginal costs are constant and equal (i.e., they are linear).
With constant output prices, the profit per unit is constant, and
the profit function that the firm may seek to maximize is linear.
Similarly, the total cost function that the firm may seek to
minimize is also linear.The limited technologically fixed input
combinations that a firm can use to produce each commodity
result in isoquants that are not smooth but will be made up of
straight line segments.

APPLICATIONS
Applied to a wide variety of constrained optimization
problems:
Most products can be manufactured by using a
number of processes, each requiring a different
technology and combination of inputs. Linear
programming can be used to determine the optimal
combination of processes needed to produce the
desired level and output at the lowest possible cost,
subject to the labor, capital, and other constraints
that the firm may face.

APPLICATIONS
A variety of products must determine how to best use their
plants, labor, and other inputs to produce the combination or
mix of products that maximizes their total profits subject to the
constraints they face.
For example, the production of a particular commodity may
lead to the highest profit per unit but may not use all the firm’s
resources.The unused resources can be used to produce
another commodity, but this product mix may not lead to
overall profit maximization for the firm as a whole. Linear
programming can determined the product mix that would lead
to profit maximization while satisfying all the constraints under
which the firm is operating.
problems:

APPLICATIONS
problems:
Production often requires that certain minimum product
requirements be met at minimum cost.
For example, the manager of a college dining hall may be required to
prepare meals that satisfy the minimum daily requirements of
protein, minerals, and vitamins at a minimum cost. Since different
foods contain various proportions of the various nutrients and have
different prices, the problem can be complex that can be solved easily
by linear programming by specifying the total cost function that the
manager seeks to minimize and the various constraints that he or she
must meet or satisfy.

APPLICATIONS
problems:
If contribution to profit each unit of the various inputs makes exceeds
the price that the firm must pay for the input, this is an indication that
the firm’s total profits would increase by hiring more of the input.
On the other hand, if the input is underused, this means that some
units of the input need not be hired or can be sold to other firms
without affecting the firm’s output.Thus, determining the marginal
contribution (shadow price) of an input to production and profits can
be very useful to the firm in its investment decisions and future
profitability.

APPLICATIONS
problems:
Applied to determine:
(a) the least-cost route for shipping
commodities from plants in
different locations to warehouses in
other locations, and from there to
different markets (the so-called
transportation problem);

APPLICATIONS
problems:
(b) the best combination of
operating schedules, payload,
cruising altitude, speed, and seating
configurations for airlines;

APPLICATIONS
problems:
(c) the best combination of logs,
plywood, and paper that a forest
products company can produce from
given supplies of logs and milling
capacity;

APPLICATIONS
problems:
(d) the distribution of a given
advertising budget amongTV, radio,
magazines, newspapers, billboards,
and

SOME BASIC CONCEPTS
It is more fully developed and more frequently
applied in production decisions.
Production analysis also represents an excellent point
of departure are introduce. It begins by defining the
meaning of a production process and deriving
isoquants. By then bringing in the production
constraints, it shows how the firm can determine the
optimal mix of production processes to use in order to
maximize output.

SOME BASIC CONCEPTS
One of the basic assumptions of linear programming is
that a particular commodity can be produced with only a
limited number of input combinations. Each of these input
combinations or ratios is called a production process or
activity and can be represented by a straight line ray from
the origin in the input space.

SOME BASIC CONCEPTS
A particular commodity can be
produced with three processes,
each using a particular
combination of labor (L) and
capital (K).
Process 1 uses 2 units of capital
for each unit of labor used,
process 2 uses 1K for each 1L
used, and process 3 uses 0.5K for
each 1L used.

SOME BASIC CONCEPTS
100 units of output (100Q) can be
produced with process 1 at pointA
(i.e., by using 3L and 6K), with
process 2 at point B (by using 4L
and 4K), or with process 3 at point
C (with 6L and 3K).
Joining these points, we get the
isoquant for 100Q.
Isoquant for 200Q with kinks at
points D (6L, 12K), E (8L, 8K), and
F (12L, 6K).

SOME BASIC CONCEPTS
The Optimal Mix of Production
Processes
 In only one constraint, such as
isocost line GH, the feasible
region, or the area of attainable
input combinations, represented
by shaded triangle 0JN is
restricted.That is, the firm can
purchase any combination of
labor and capital on or below
isocost lineGH.The best or
optimal solution is at point E
where the feasible region reaches
the isoquant for 200Q (the
highest possible).Thus, the firm
produces the 200 units of output
with process 2 by using 8L and 8K.

SOME BASIC CONCEPTS
Processes
The figure extends the analysis to the
case where the firm faces no cost
constraint but has available only 7L
and 10K for the period of time under
consideration.The feasible region is
then given by shaded area 0RST. Only
those labor-capital combinations in
shaded area 0RST are relevant.The
maximum output that the firm can
produce is 200Q and is given by point
S.That is, the isoquant for 200Q is the
highest that the firm can reach with
the constraints it faces.To reach point
S, the firm will have to produce 100Q
with process 1 (0A) and 100Q with
process 2 (0B AS).3

SOME BASIC CONCEPTS
Processes
 When the firm faced the single isocost constraint, the firm used only one
process (process 2) to reach the optimum.When the firm faced two constraints
(the 2nd graph), the firm required two processes to reach the optimum. From
this, we can generalize and conclude that to reach the optimal solution; a firm
will require no more processes than the number of constraints that the firm
faces.
 For example, if the firm could use no more than 6L and 12K, the optimum
would be at point D (200Q), and this is reached with process 1 alone. If the ratio
of the wage rate (w) to the rental price of capital (r) increased (so that isocost
line GH became steeper), the optimal solution would remain at point E as long
as the GH isocost (constraint) line remained flatter than segment DE on the
isoquant for 200Q. If w/r rose so that isocost GH coincided with segment DE,
the firm could reach isoquant 200Q with process 1, process 2, or any
combination of process 1 and process 2 that would allow the firm to reach a
point on segment DE. If w/r rose still further, the firm would reach the optimal
solution (maximum output) at point D .

PROCEDURE USED IN FORMULATING
AND SOLVING PROBLEMS
The most difficult aspect of solving a constrained optimization problem is to
formulate or state the problem in a linear programming format or framework.
There are simple linear programming problems with only a few variables and
more complex problems. It is important, to know the process and how the
results are interpreted.
It begins by defining some important terms and then using them to outline the
steps to follow in formulating and solving linear programming problems.
 objective function - function to be optimized in linear that refers to profit
maximization or cost minimization
 inequality constraints - constraints are given by inequalities that the firm can
often use up to, but not more than, specified quantities of some inputs, or the
firm must meet some minimum requirement
 nonnegativity constraints - on the solution to indicate that the firm cannot
produce a negative output or use a negative quantity of any input
 decision variables – quantities of each product to produce in order to maximize
profits or inputs to use to minimize costs

PROCEDURE USED IN FORMULATING
AND SOLVING PROBLEMS
The steps followed in solving a linear programming problem
are:
1. Express the objective function of the problem as an equation and the
constraints as inequalities.
2. Graph the inequality constraints, and define the feasible region.
3. Graph the objective function as a series of isoprofit (i.e., equal profit) or
isocost lines, one for each level of profit or costs, respectively.
4. Find the optimal solution (i.e., the values of the decision variables) at the
extreme point or corner of the feasible region that touches the highest
isoprofit
line or the lowest isocost line.This represents the optimal solution to the
problem subject to the constraints faced.

PROFIT MAXIMIZATION
Formulation of the Problem
Assume that the firm produces only two products: product X
and productY. Each unit of product X contributes $30 to
profit and to covering overhead (fixed) costs, and each unit
of productY contributes $40.5 Suppose also that in order to
produce each unit of product X and productY, the firm each
unit of product X requires 1 unit of input A, one-half unit of
input B, and no input C, while 1 unit of productY requires 1A,
1B, and 0.5C.

PROFIT MAXIMIZATION
Input Requirements and Availability for Producing Products X andY
Table shows that the firm has available only 7 units of inputA, 5 units of input B,
and 2 units of input C per time period.
The firm then wants to determine how to use the available inputs to produce the mix
of products X andY that maximizes its total profits.

PROFIT MAXIMIZATION
Formulation of the Problem:
Objective Function
Since each unit of product X contributes $30 to profit and
overhead costs and each unit of productY contributes
$40, the objective function that the firm seeks to
maximize is ∏ = $30QX + $40QY
This equation postulates that the total profit
(contribution) function of the firm equals the per-unit
profit contribution of product X times the quantity of
product X produced plus the per-unit profit contribution
of productY times the quantity of productY that the firm
produces.

PROFIT MAXIMIZATION
Constraints as Inequalities
1 unit of input A is required to produce each unit of product X
and productY and that only 7 units of input A are available to
the firm per period of time.Thus, the constraint imposed on
the firm’s production by input A can be expressed as 1QX +
1QY ≤ 7.
The 1 unit of input A required to produce each unit of product
X times the quantity of product X produced plus the 1 unit of
input A required to produce each unit of productY times the
quantity of productY produced must be equal to or smaller
than the 7 units of input A available to the firm.

PROFIT MAXIMIZATION
From the second row, one-half unit of input B is required
to produce each unit of product X and 1 unit of input B is
required to produce each unit of productY, and only 5
units of input B are available to the firm per period of
time.The quantity of input B required in the production of
product X is then 0.5QX, while the quantity of input B
required in the production of productY is 1QY and the
sum of 0.5QX and 1QY can be equal to, but it cannot be
more than, the 5 units of input B available to the firm per
time period.Thus, the constraint associated with input B
is 0.5QX + 1QY ≤ 5

PROFIT MAXIMIZATION
From the third row, the input C is not used in the
production of product X, one-half unit of input C is
required to produce each unit of productY, and only 2
units of input C are available to the firm per time period.
Thus, the constraint imposed on production by input C is
0.5QY ≤ 2

PROFIT MAXIMIZATION
Nonnegativity Constraints
To make economic sense, nonnegativity constraints must
impose on the output of products X andY.The reason is
that the firm can produce zero units of either product, but
it cannot produce a negative quantity of either product
(or use a negative quantity of either input).The
requirement that QX and QY (as well as that the quantity
used of each input) be nonnegative can be expressed as
QX ≥ 0 QY ≥ 0

PROFIT MAXIMIZATION
Summary

PROFIT MAXIMIZATION
Graphic Solution
The next step is to treat the inequality constraints of the
problem as equations, graph them, and define the
feasible region.
The graph shows the constraint imposed on the
production of products X andY by input A. Treating
inequality constraint for input A as an equation (i.e.,
disregarding the inequality sign for the moment), we have
1QX + 1QY ≤ 7.With 7 The shaded area in part a shows
the inequality constraint from input A. Units available in the
firm could produce 7 units of product X (that is, 7X) and no
units of productY, 7Y and 0X, or any combination of X andY
on the line joining these two points. Inequality constraint
refers to all the combinations of X andY on the line and in
the entire shaded region below the line.

PROFIT MAXIMIZATION
Graphic Solution
We have limited the feasible region
further by considering the constraints
imposed by the availability of inputs B
and C.The constraint on input B can be
expressed as the equation:
0.5QX + 1QY ≤ 5.
Thus, if QX = 0, QY = 5, and if QY = 0, QX
= 10. All the combinations of product X
and product Y falling on or to the left of
the line connecting these two points
represent the inequality constraint for
input B.The horizontal line at QY = 4
represents the constraint imposed by
input C.
There is no constraint on the production
of product X because it is not used in the
production.

PROFIT MAXIMIZATION
Graphic Solution
The lowest isoprofit line is
obtained by substituting
$180 for ∏ into the
equation for the objective
function and then solving
for QY. Substituting $180
for ∏ in the objective
function, we have $180 =
$30QX + $40QY. Solving for
QY, we obtain: QY = $ 240/
$ 40 – ($ 30/ $ 40)QX.

PROFIT MAXIMIZATION
Graphic Solution
Determine the mix of products X and Y (the
decision variables) that the firm should
produce in order to reach the highest isoprofit
line. It shows that the highest isoprofit line
that the firm can reach subject to the
constraints it faces
is HJ.This is reached at point E where the firm
produces 4X and 3Y and the total contribution
to profit (∏) is maximum at $30(4) + $40(3) =
$240. Point E is at the intersection of the
constraint lines for inputs A and B but
below the constraint line for input C that
means inputs A and B are fully utilized, while
input C is not.
In the terminology of linear programming,
inputs A and B are binding constraints, while
input C is nonbinding or is a slack variable.

PROFIT MAXIMIZATION
Extreme Points and the Simplex
Method
Graph shows the case of multiple
optimal solutions.
The new isoprofit line H’ J’ ($240
_=$24QX + $48QY) has the
absolute slope of $24/$48 = 1/2 ,
the same as segment EF of the
feasible region.Thus, all the
product mixes along EF, including
those at corner points E and F,
result in the same value of ∏=
$240.
For example, at point M (3X, 3.5Y
) on EF, ∏ =$24(3) + $48(3.5)
=$240.

PROFIT MAXIMIZATION
Extreme Points and the Simplex
Method
“extreme-point theorem” – refer to all the computer
programs available for solving linear programming
problems start by arbitrarily picking one corner and
calculating the value of the objective function at that
corner, and then systematically moving to other corners
that result in higher profits until they find no corner with
higher profits.
simplex method - method of solution

PROFIT MAXIMIZATION
Outputs of Product X andY, and Profits
at Each Corner of the Feasible Region
The firm can use this information to determine how much of each
binding input it should hire in order to expand output by a desired
amount, or how much of the slack inputs it does not need to hire or it can
rent out to other firms (if it owns the inputs) at the profit-maximizing
solution.

COST MINIMIZATION
Assume that the manager of a college dining hall is required to prepare
meals that satisfy the minimum daily requirements of protein (P ),
minerals (M), and vitamins (V ). The manager wants to provide meals
that fulfill the minimum daily requirements of protein, minerals, and
vitamins at the lowest possible cost per student.

COST MINIMIZATION
The linear programming problem can be formulated as follows:
Minimize C = $2QX + $3QY (objective function)
Subject to 1QX +2QY ≥ 14 (protein constraint)
1QX + 1QY ≥ 10 (minerals constraint)
1QX +0.5QY ≥ 6 (vitamins constraint)
QX, QY ≥ 0 (nonnegativity constraint)
The inequality constraints are nowexpressed in the form of “equal to or
larger than” since the minimum daily requirements must be fulfilled but
can be exceeded.
Finally, nonnegativity constraints are required to preclude negative values
for the solution.

COST MINIMIZATION
The feasible region is then given by
the shaded area above DEFG. All
points in the shaded area
simultaneously satisfy all the
inequality and nonnegativity
constraints of the problem.
In order to determine the mix of
foods X and Y (that is, QX and QY)
that satisfies the minimum daily
equirements for protein, minerals,
and vitamins at the lowest cost
per student, we superimpose cost
line HJ on the feasible regiion.

COST MINIMIZATION
HJ is the lowest isocost line that
allows the firm to reach the
feasible region. It has an absolute
slope of , which is the ratio of the
price of food X to the price of
food Y and is obtained by solving
the cost equation for QY.
Cost line HJ touches the feasible
region at point E.Thus, the
manager minimizes the cost of
satisfying the minimum daily
requirements of the three
nutrients per student by using 6
units of food X and 4 units of
food Y at a cost of C = ($2)(6) +
($3)(4) =$24

COST MINIMIZATION
Costs are higher at any other corner or point inside the
feasible region.
Point D, C=($2)(14)=$28, at point F,
C=($2)(2)=($3)(8)=28, and point G, C=($3)(12)=$36
Point E is formed by the intersection of the constraint
lines for nutrient P (protein) and nutrient
M(minerals) but is above the constraint line for
nutrient V (vitamins). This means that the
minimum daily requirements for nutrients P and M
are just met while the minimum requirement for
nutrient V is more than met.
If the price of food X increases from $2 to $3 (so that
the ratio of the price of food X to the price of food
Y is equal to 1), the lowest isocost line that reaches
the feasible region would coincide with segment
EF of the feasible region. In that case, all the
combinations or mixes of food X and food Y along
the segment would result in the same minimum

COST MINIMIZATION
The Foods X andY, and Cost at Each
Corner of the Feasible Region

THE DUAL PROBLEM AND
SHADOW PRICES
primal problem - linear programming problem
dual problem - a corresponding or symmetrical problem
A profit maximization primal problem has a cost minimization
dual problem, while a cost minimization primal problem has
a profit maximization dual problem.
shadow prices - solutions of a dual problem
- it gives the change in the value of the objective
function per unit change in each constraint in the primal
problem.
For example, the shadow prices in a profit maximization
problem indicate how much total profits would rise per unit
increase in the use of each input.

SHADOW PRICES
Shadow prices thus provide the imputed value or marginal
valuation or worth of each input to the firm. If a particular
input is not fully employed, its shadow price is zero because
increasing the input would leave profits unchanged. A firm
should increase the use of the input as long as the marginal
value or shadow price of the input to the firm exceeds the
cost of hiring the input.
Shadow prices provide important information for planning and
strategic decisions of the firm.

SHADOW PRICES
Shadow prices are also used:
(1) by many large corporations to correctly price the output of
each division that is the input to another division, in order to
maximize the total profits of the entire corporation,
(2) by governments to appropriately price some government
services, and
(3) For planning in developing countries where the market
system often does not function properly

SHADOW PRICES
DualityTheorem
The dual problem is formulated directly from the
corresponding primal problem.The optimal value of the
objective function of the primal problem is equal to the
optimal value of the objective function of the
corresponding dual problem.

SHADOW PRICES
The Dual of Profit Maximization
Dual problem for the constrained profit maximization
problem:

SHADOW PRICES
We seek to minimize the imputed values, or shadow
prices, of inputs A, B, and C used by the firm. Defining VA, VB, and
VC as the shadow prices of inputs A, B, and C, respectively, and C as
the total imputed value of the fixed quantities of inputs A, B, and C
available to the firm, we can write the dual objective function as:
Minimize C=7VA +5VB + 2VC
The constraints of the dual problem postulate that the sum of the
shadow price of each input times the amount of that input used to
produce 1 unit of a particular product must be equal to or larger than the
profit contribution of a unit of the product.Thus, we can write the
constraints of the dual problem as:
1VA + 0.5VB ≥ $30
1VA + 1VB + 0.5VC ≥ $40

SHADOW PRICES
Summarizing the dual cost minimization problem and adding the
nonnegativity constraints, we have:
Minimize C = 7VA +5VB + 2VC (objective function)
Subject to 1VA + 0.5VB ≥ $30
1VA + 1VB + 0.5VC ≥ $40
VA,VB, BC ≥ 0
The direction of the inequality constraints in the dual problem is opposite
that of the corresponding primal problem and that the shadow prices cannot
be negative (the nonnegativity constraints in the dual problem).
That is, we find the values of the decision variables (VA, VB, and VC) at
each corner and choose the corner with the lowest value of C.

SHADOW PRICES
:The algebraic solution is simplified because in this case we know from the
solution of the primal problem that input C is a slack variable so that VC equals
zero. Setting VC _ 0 and then subtracting the first from the second constraint,
treated as equations, we get:
1VA + 1VB =$40
1VA + 0.5VB =$30
0.5VB =$10
VB =$20
This means that increasing the amount of input A or input B by 1 unit would
increase the total profits of the firm by $20, so that the firm should be willing to
pay as much as $20 for 1 additional unit of each of these inputs.

SHADOW PRICES
The Dual of Cost Minimization
Objective cost function: C = 7($20) +5($20) + 2V($0) = $240
This is the minimum cost that the firm would incur in producing
4X and 3Y. The maximum profits found in the solution of the
primal problem (that is ∏ = $240) equals the minimum cost in the
solution of the corresponding dual problem (that is, C = $240) as
dictated by the duality theorem.

SHADOW PRICES
Minimize C = $2QX + $3QY (objective function)
Subject to 1QX +2QY ≥ 14 (protein constraint)
1QX + 1QY ≥ 10 (minerals constraint)
1QX +0.5QY ≥ 6 (vitamins constraint)
QX, QY ≥ 0 (nonnegativity constraint)
The corresponding dual profit maximization problem can be
formulated as follows:
∏ = 14VP + 10VM +6VV
1VP + 1VM + 1VV ≤ $2
2VP + 1VM + 0.5VV ≤ $3
VP,VM,VV ≥ 0

SHADOW PRICES
Since we know from the solution of the primal problem that the vitamin constraint
is a slack variable, so that VV = 0, subtracting the first from the second constraint,
treated as equations, we get the solution of the dual problem of:
2VP + 1VM =3
1VP + 1VM =2
1VP =1
Substituting VP = $1 into the second equation, we get VM = $1, so that
∏ = 14($1) + 10($1) + 6($0) = $24
This is equal to the minimum total cost (C) found in the primal problem. If the profit
contribution resulting from increasing the protein and mineral constraints by 1 unit
exceeds their respective marginal cost or shadow prices (that is, VP and VM), the
total profit of the firm (that is, ∏) would increase by relaxing the protein and
mineral constraints. On the other hand, if the profit contribution resulting from
increasing the protein and mineral constraints
by 1 unit is smaller than VP and VM, ∏ would increase by reducing the protein and
mineral constraints.

LOGISTICS INTHE GLOBAL ECONOMY
logistic management - refers to the merging at the corporate level
of the purchasing, transportation, warehousing, distribution, and
customer services functions, rather than dealing with each of
them separately at division levels
Monitoring the movement of materials and finished products from
a central place can reduce the shortages and surpluses that
inevitably arise when these functions are managed separately.
Linear programming, which in the past was often profitably used to
solve specific functional problems (such as purchasing,
transportation, warehousing, distribution, and customer
functions) separately, is now increasingly being applied to solve all
these functions together with logistic management.

Managerial economics linearprogramming

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