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MANAGERIAL

DECISION MAKING
AND MATHEMATICAL
OPTIMIZATION PROBLEMS
DECISION MAKING
•  Consider the problem of a mall builder:

Strong demand Weak demand


Small complex 8 7
Medium 14 5
complex
Large complex 20 -9

•  Op>mist: maximum pay-off


Strong demand Weak demand
Small complex 8 7
Medium 14 5
complex
Large complex 20 -9

Conserva>ve:
- For a max problem: Maximin
- For a min problem: Mininmax
Strong demand Weak demand
Small complex 8 7
Medium 14 5
complex
Large complex 20 -9

Minimax regret approach


- Minimizing the maximum opportunity loss
(regret) that could occur overall possible states of
nature
Rij = Vj * −Vij

Rij = regret associated with alterna>ve i under state of nature j


VJ* = payoff of the best decision for state of nature j
Vij = payoff of alterna>ve i under state of nature j
Regret or Opportunity Loss
Strong demand Weak demand
Small complex 12 0
Medium 6 2
complex
Large complex 0 16

Maximum Regret
Small complex 12
Medium complex 6
Large complex 16
•  Maximizing expected value
- Assume the probability of strong demand is 80%.

Strong Weak Expected


demand demand value
Small 8 7 7.8
complex
Medium 14 5 12.2
complex
Large 20 -9 14.2
complex
Minimizing expected opportunity loss
- Assume the probability of strong demand is 80%.

Strong Weak Expected


demand demand opportunity
loss
Small 12 0 9.6
complex
Medium 6 2 5.2
complex
Large 0 16 3.2
complex
SCOPE OF MANAGERIAL ECONOMICS
•  Douglas : “Managerial economics is .. the
applica>on of economic principles and
methodologies to the decision-making process
within the firm or organiza>on.”

•  Salvatore : “Managerial economics refers to the


applica>on of economic theory and the tools of
analysis of decision science to examine how an
organisa>on can achieve its objec>ves most
effec>vely.”
•  Brander and Perloff : “Managerial economics
is the applica>on of economic analysis to
managerial decision making. It focuses on how
managers make economic decisions by
alloca>ng scarce resources at their disposal.”
MANAGEMENT DECISION PROBLEMS
•  Product price and output
•  Produc>on technique
•  Make or buy
•  Inventory level
•  Adver>sing medium and intensity
•  Labor hiring and training
•  Investment and financing
Mathematical Optimization Problem
•  MOP involves choosing values of certain variables to
op>mize a func>on subject to constraints.

•  The variables are called instruments.

•  The func>on to be op>mized is the objecRve funcRon.

•  The instrument x is feasible if it sa>sfies all the


constraints of the problem. The set of all feasible x is
the opportunity set X.

Max f(x) subject to x ∈ X


Mathematical programming problems
a) Classical programming – equality constraints

g1(x) = gs(x1, ...., xn) = b1


g2(x) = g2(x1, ...., xn) = b2
.
.
gm(x) = gs(x1, ...., xn) = bm
where g1(x), g2(x), ...., gm(x) are called constraint
functions, b1, b2, ..., bm are called constraint constants.

Example:
Min C(x) subject to output constraint
b) Nonlinear programming - nonnega>vity constraints
and inequality constraints
g1(x) = gs(x1, ...., xn) ≤ b1
g2(x) = g2(x1, ...., xn) ≤ b2
.
.
gm(x) = gs(x1, ...., xn) ≤ bm
x1 ≥ 0, x2 ≥ 0, ...., xn ≥ 0

Example:
Max sales subject to profit constraint
c) Linear Programming - the objec>ve func>on is linear
and the constraints are linear inequality constraints and
nonnega>vity constraints
f(x) = c1x1 + c2x2 + .... + cnxn

subject to
a11 x1 + a12 x2 + .... + a1n xn ≤ b1
a21 x1 + a22 x2 + .... + a2n xn ≤ b2
.
.
am1 x1 + am2 x2 + .... + amn xn ≤ bm

x1 ≥ 0, x2 ≥ 0, ...., xn ≥ 0

Example: Finding op>mal combina>on of commodi>es to be


produced and processes by which these goods would be produced.
Geometrical Solution to the Mathematical
Optimization Problem

•  A contour of the objective function is the set of


points for which the value of the objective function is
constant.
•  The set of contours is a contour map.

•  The preference direction is the direction in which the


value of the objective function is increasing fastest.

•  The mathematical optimization problem is choosing


a point or set of points in the opportunity set at the
highest possible contour.
Possible solutions to the programming problem:

a) Classical Programming
max U = xy subject to M = pxx + pyy

tangency solution
y

M = pxx + pyy
x
b) Nonlinear Programming
Max F(x1, x2) = -8x12 - 10x22 + 12x1x2 - 50x1 + 80x2
subject to x1 + x 2 ≤ 1
8x12 + x22 ≤ 2
x1 ≥ 0, x2 ≥ 0
x2
Boundary solution at (0, 1)

••

x1
x2

x1

Interior solution
c) Linear Programming
Max F = 3x1 + 2x2
subject to: 2x1 + x2 ≤ 6
x1 + 2x2 ≤ 8
x1 ≥ 0, x2 ≥ 0
x2

Vertex solution at (4/3, 10/3).

x1
x2

x1
Bounding face solution

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