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A Representation and Economic Interpretation of a Two-Level Programming Problem

Author(s): José Fortuny-Amat and Bruce McCarl

Reviewed work(s):
Source: The Journal of the Operational Research Society, Vol. 32, No. 9 (Sep., 1981), pp. 783-
Published by: Palgrave Macmillan Journals on behalf of the Operational Research Society
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J. OplRes.Soc.Vol.32,pp.783to 792,1981 0160-5682/81/090783-10X02.00/0
Printed Allrightsreserved
inGreatBritain. Copyright SocietyLtd
? 1981Operational

A and Economic Interpretation


of a Two-Level Programming Problem


Graduate School of Administration, University of California, Riverside, California, U.S.A. and Purdue Univer?
sity, West Lafayette, Indiana, U.S.A.

This paper first presents a formulation for a class of hierarchial problems that show a two-stage
decision making process; this formulation is termed multilevel programming and could be defined, in
general, as a mathematical programming problem (master) containing other multilevel programs in
the constraints (subproblems). A two-level problem is analyzed in detail, and we develop a solution
procedure that replaces the subproblem by its Kuhn-Tucker conditions and then further transforms
it into a mixed integer quadratic programming problem by exploiting the disjunctive nature of the
complementary slackness conditions.
An example problem is solved and the economic implications of the formulation and its solution
are reviewed.


In this paper we focus our attention on a two-level programming problem, which is

defined as follows:

max dxu + d2x + (w, x) R(u, 5c) (1.1)


kxu + k2 x ^ k0 (1.2)

max cx + (w, x)' Q(u, x) (1.3)

Du + Ax ^ b (1.4)

x > 0 (1.5)


u is an n x 1 vector of decision variables for the master problem,

x is a p x 1 vector of decision variables for the subproblem,
x/u expresses the two stage character of the problem: x is set after u has been
There are many planning and/or decision making situations that can be properly
represented by a multilevel programming model. All of them appear wherever a hierar?
chical structure is present and, in general, can be characterized as follows:
(1) There are two or more decision makers (DM) involved in the process, with inde?
pendent and sometimes conflicting goals, at the same or different levels of the hierarchy.
(2) Each DM can exercise direct control over only certain variables.
(3) For each two adjacent levels in the decision tree, the decision making process is
carried out in two sequential stages: first, the DM at level 1 (higher level) announces his
plan of action; in the second stage, the DM at level 2 (lower level) reacts rationally to the
plan put forth by the DM of level 1, i.e. the plan announced by the DM of level 1 is taken
as exogenous data, and the lower level DM independently optimizes his plan of action
according to his goals and limitations, disregarding the goals of the DM at level 1.
(4) The problem ofthe DM at level 1, the principal object of our analysis, is to select a
plan of action that optimizes his objective subject to the rational reaction of the DM at
level 2.


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Journal of the Operational Research Society Vol. 32, No. 9

(5) There is no uncertainty involved in the decision making process. In principle, the
DM at level 1 knows the objective function and the constraints of the subproblem.
Before presenting some examples, let us analyze the nature of the interaction between
the master problem (optimization problem of the DM at level 1) and the subproblem
(optimization problem of the DM at level 2), as formulated in PI. When the master
decision variables are set at a particular level, u = u, they influence the subproblem in
two ways: (1) through the constraints, Ax ^ b ? Du, directly manipulating the avail?
ability of resources (this case arises when the master has the power to allocate resources,
or in an economy under rationing); and (2) through the objective function in its quad?
ratic term, thus allowing us to portray pricing policy considerations as well as synergetic
changes between the master's decision variables and the subproblem variables. Now,
when the subproblem is optimized, the master problem may be required to change the
settings of its variables because the new values for the subproblem's variables x = x may
now turn constraints (1.2) infeasible and/or modify optimality considerations (1.1). As
formulated, problem (PI) allows such feedback to the master problem which, in turn,
uses it in the search for an optimal setting of its decision variables. Therefore, a two-way
interaction pattern is established and it will terminate in either an optimal state for both
master and subproblem or in an infeasible state.


The problem just defined can be found in many decision making situations, some of
which are now detailed.

Case 1
Candler and Norton1 presented a version of this problem in an economic policy
context: the government determines certain goals to be achieved during the planning
period, and in order to optimize their achievement, the government can use certain
policy measures such as taxes and subsidies. Once the policy measures are announced,
the private sector reacts to the government policy measures by optimally forming a plan
of action. This private sector plan, however, may not be what the government antici-
pated. Further, the reaction of the private sector, together with the government's posted
policy measures will jointly determine the degree of achievement of the government's
economic goals. In any problem of this nature and, in general, in an economic policy
problem in which the government's objectives are at least in partial conflict with the
private sector goals, the policy makers face an optimization problem subject to the
optimization problems for industries and consumers.
As an example of this process, consider the milk manufacturing industry. Assume that
the particular goal selected by the policy makers for this sector is the reduction in the use
of imported fuel. To achieve this objective, the policy makers can impose taxes on
imported fuels; they can also subsidize industries' use of domestically produced energy
sources and/or industries' installation of certain energy efficient processes, such as heat
recovery devices. Once the detailed structure of taxes and subsidies has been put forth by
the government, industry will decide on its production plans. In the end, the industries'
use of imported fuels may either rise, remain the same as before, or diminish. The fact
that industries react in accordance to their own objectives to any set of policy measures,
and with disregard to the goals of the economy, forces the policy makers, in this case, to
use a strategy such that the use of imported fuels is minimized given that the industries
will react rationally according to their goals and limitations.

Case 2
Assume a distribution centre supplying products to customers in a certain area which
is also served by a competitor. Our distribution centre must set a price level for its
products such that its profits are maximized. However, the customers can buy either
from the distribution centre or from competitors, depending on the relative prices of the

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J. Fortuny-Amat and B. McCarl?A Two-level Programming Problem

product. In making this decision to buy, the customers will consider (excluding brand
loyalty considerations) economic criteria such as cost minimization. There, again, the
distribution centre faces a mathematical programming problem subject to the optimiza?
tion problem of the customers.

Case 3
Consider the case of farming communities that use irrigation; frequently, during the
growing season, the water supply is not sufficient to entirely cover the requirements of all
possible water use patterns. Thus some kind of entity (maybe a government agency) is
usually placed in charge of allocating water. Evidently, no matter what the allocation
criteria are the farmers will try to optimize their production according to their resources
and the allotted water supply. Therefore, the entity in charge could wish to optimize its
criteria for water distribution subject to the optimization problems of the farmers.



Multilevel programming problems have been previously discussed both as multilevel

problems and under different bodies of economic theory. The oldest formal area of
enquiry is through game theory wherein the game has a leader and a follower. The
multilevel problem is similar to the Stackelberg game framework of game theory. Simaan
and Cruz4 show how a Stackelberg strategy can be used by the leader (player who
announces his strategy first) to dominate the outcome of the game, given the rational
reaction ofthe follower; they show that the use of a Stackelberg strategy yields at least as
good or better payoff to the leader than the Nash equilibrium solution. Candler and
Norton1 solved a relatively large-scale model of Mexican agriculture; later Candler and
Townsley9 developed an algorithm to solve a special case of the multilevel programming
problem by exploiting at each cycle all the gradient information gathered along the way.
Also in the economic policy context, Sparrow2 presents a similar type of model for the
analysis of energy conservation policies in the iron and steel industry and proposes the
use of grid search procedures to determine the optimal solution. Other authors11,12 have
concentrated their attention on the distribution of resources among the subproblems and
have developed procedures to allow the master to perform such allocation fairly and
efficiently. Bialas and Karwan3 have presented other examples in the areas of control of
oil imports, floodplain planning and job incentive programmes: they suggest a solution
algorithm which is basically a modified bounded variables simplex, but their procedure
can only guarantee local optima and global optima for certain 'easy' problems.
A simpler version of our problem has been dealt with by Falk.5 In fact, he looked at a
particular case of our problem which arises when the objective function of the master is
in total opposition to that of the subproblem. In this way, he reduces the problem to a
max-min situation and presents an algorithm to solve this particular case.
Other authors6-8 have looked at the multilevel programming problem with and with?
out constraints linking the decision variables of master and subproblems. The algorithms
to date for the problem have been heuristic or local optimizing approaches. Candler and
Townsley have obtained a global procedure10 for the case when the master problem can
affect the subproblem's solution space but not its objective function. At the point where
we were giving the finishing touches to this paper, Bard and Falk13 came out with
another global optimizing procedure for the multilevel programming problem.


As described in the previous sections, the subproblem will be optimized once the master's


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Journal ofthe Operational Research Society Vol. 32, No. 9

decision variables have been set, i.e. for u = u, the subproblem becomes

max cx + (u, x)' Q(u, x)
Ax ^ b - Du

x ^ 0.
Note that the interaction of u leaves the objective function terms to be qxu, which
would reflect (qu)x as a subsidized or taxed price of x. Further note that the objective
function is at most quadratic in x, which will yield a set of Kuhn-Tucker conditions
conveniently linear.
Problem (P2) is a quadratic programming problem in x and can be rewritten in a more
compact form by eliminating the quadratic terms involving u that are now constant or
linear in x:

max c?x + x'Q?x + k
Ax ^ b - Du

c? = cj + ^iqijUi or c? = c + u'Q1

k = Xiquuf

and the array Q? is now anwxn symmetric array that has been formed by eliminating
from Q those elements that gave rise to cross products ux and quadratic terms in u, and
Q1 is an m x p matrix of interactions between u and x, also drawn from Q.
Since for any u, the subproblem, in its new form (P3), will be optimized, we can now
introduce the following definitions:
Definition 1: A feasible solution to problem PI is a vector (u,x) such that problem (P3)
is optimal and constraints (1.2) are satisfied.
Definition 2: An optimal solution to problem (PI) is a feasible solution that maximizes
(1.1), the master's objective function.
With these definitions in mind, we can now construct an equivalent formulation for
Problem (PI), as follows: The necessary conditions for optimality of the subproblem,
(P3), are given by its Kuhn-Tucker conditions, which are:
- + v = - c?
2Q?x Ay

Ax + vv = b ? D u

y'w = 0
x'v = 0

x, >\ vv, v ^ 0

for any u = u, and where y is the m x 1 vector of Lagrange multipliers. Sufficiency

is dependent upon the nature ofthe matrix Q?.
Hence, we can rewrite (PI) as
max dxu + d2x + (u,x)' R(u,x) (VA)
kxu + k2x ^ k0 (V.2)
- - c -
2Q?x Ay + i: = u'Q1 (1'.3)
Du + Ax + vv == b (1'.4)

y'w = 0 (1\5)


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J. Fortuny-Amat and B. McCarl?A Two-level Programming Problem

x'v = 0 (1'.6)

u,x,y,w,v ^ 0 (1'.7)
where (V.3)-(V.l) are a general expression of the subproblem's Kuhn-Tucker conditions
and guarantee the global optimality of (P2) for all possible values of the master's decision
variables, w, provided the solution space is not empty and Q? is of the appropriate form
(negative definite or semidefinite in the maximization case). Recall that optimization is
now in (w, x, y, w, v) space.
This constructive procedure can be summarized in the following theorem, whose proof
is trivial.
Theorem 1
A vector (w, x), optimal for problem (PT), will be an optimal solution to problem (Pl).
The only remaining difficulty for the solution of (PT) arises when we consider the
complementary slackness conditions (1'.5) and (1'.6). If we examine these conditions, we
see that they coiisist of sums of products of two variables, and we know that y}w} = 0 for
all j or, in LP terms, if yi > 0, then the primal constraint is binding, Wj = 0; or if the
constraint is not binding, its shadow price is zero. We can now use this disjunctive nature
of the complementary conditions to transform problem (Pl') into an equivalent mixed
integer quadratic problem which can be solved by existing methods.
The procedure is then as follows: remove (1'.5) and (1'.6) from (Pl'). Then, for each
product yjWj (same for the xv products), add a zero-one variable, rjj to the problem and
append the following two constraints to (Pl'):

yj < M1j

where M is a large positive constant. After completion of this procedure, we have the
following problem:

max dxu + d2x + (w, x)' R(u, x) (1"-1)

kxu + k2x ^ k0 (1".2)

2Q?x -A'y + v= -c- u' Q1 (1".3)

Du + Ax + w = b (r.4)

y ^ Mn (1".5)
w ^ M(q- n) (1".6)

x ^ Mfi (1".7)
v ^ M(e -
fi) (1".8)

w,x, y, w, v ^ 0 (1".9)

1, i*? [0,1]. (l'MO)

Problem (Pl") is equivalent to problem (Pl').

It is important to note that problem (Pl) (or any of its equivalent formulations) is not
a convex programming problem and, therefore, any solution procedure attempting to
find a global optimum must devise a system to partially enumerate the solution space; if
this is not done, only local optima can be guaranteed (see, for example, Bialas and
Karwan3 and Candler and Townsley9).
Our solution procedure yields a global optimum of (Pl), if one exists and given a
proper R and Q?, because it deals with the combinatorial nature of the problem (arising
from the complementary slackness conditions) in an enumerative way. The procedure
may terminate in one of two states: (1) either an optimal solution is obtained, or (2) an


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Journal ofthe Operational Research Society Vol. 32, No. 9

infeasible solution is obtained, in which case the subproblem is either infeasible or

unbounded, or the constraints (1".2) are infeasible.
Notice that (PT) could be solved directly (and still yield an optimum for (PI)) by using
the special ordered sets (SOS) feature of some mathematical programming packages (for
instance APEX III). Using such a feature is conceptually equivalent to the additions
proposed to obtain (PI"). The advantage of using SOS is that the constraint set does not
have to be enlarged beyond the Kuhn-Tucker conditions for the subproblem (even the
complementary slackness conditions are replaced by the SOS), and that seems to prove
more efficient computationally than the integerized formulation.


We present and solve here a particularly simplified version of the problem introduced as
example 2, in this case applied to a fertilizer dealer.
The farmers of a certain region can buy anhydrous ammonia from a fertilizer dealer
settled in the region or from a competitor in a neighbouring region. All dealers offer five
alternative purchasing systems:
(1) at plant,
(2) delivered,
(3) delivered and applied,
(4) at plant with applicator rental,
(5) delivered with applicator rental.
The dealer of the neighbouring region has put forth a price list for each of the
alternatives and our dealer has now to decide about the base price to use in order to
maximize his profit.
The farmers will buy from the dealers only for economic reasons; i.e. they want to
minimize the cost of fertilizer (assuming the farmers wish a fixed quantity of fertilizer).
The dealer's problem can then be formulated as a two-level mathematical programme,
as follows:
max [P0 - C]Q

<7i2 + <7i3 + <7i5 < DT

<7i3 + <7i4 + <7i5 ^ DA

5 _ _
dealer's equipment constraints

5 5
min X Pijqij + I P2Jqj
Qij/Poj = 1 j= 1

= Qn
I I Qtj
i=l ]=1

Z (qn + 4n) ^ Tn
i== 1i
2 _ farmers' subproblem
? fei + qn) < An

i=l,2;; = l,...,5


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J. Fortuny-Amat and B. McCarl?A Two-level Programming Problem

= fertilizer bought from dealer in region using purchasing alternative);
= same for competitor;
= price if bought from dealer in region;
= price if bought from competitor;
Q = fixed quantity of fertilizer each farm requires;
T = farmer's truck capacity for delivery;
A = applicator's capacity at the farm;
L = labour available at each farm;
= labour required per unit of fertilizer applied;
n, = number of farmers within the region;
C = dealer's cost of purchasing the fertilizer;
DT = dealer's truck capacity;
DA = dealer's applicator capacity;
DL = dealer's labour availability;
= dealer's labour required per unit of fertilizer applied;
Q = quantity sold by the fertilizer dealer.

The base price, P0, is related to the purchase price for the farmer as follows:



Po = base price of fertilizer;

t = delivery charge per unit per mile;
r_ distance from dealer to average farmer in the region;
a = application charge per unit applied;
y = applicator rental charge per unit applied.
This basic problem can be transformed into its (Pl') equivalent form to obtain Figure
1 and the complementary conditions yw and qv.
At this point we can either transform the problem into a QP with integer variables or
solve it directly by branch and bound,
i.e. solving a QP at each node. If the solution
satisfies all complementary then it is optimal; if not, take the most violated
complementary condition, say, ykwh and create two new problems whose constraints are
the same as the constraints of the problem just solved plus one of the upper bounds,
yk ^ 0, wk ^ 0, in each problem. The process should continue in this fashion until all
complementary conditions are satisfied and fathoming is complete. This procedure also
yields a global optimum, if one exists, for the same reasons explained in the previous
We solved the fertilizer dealer problem by branch and bound to obtain the results
given in Tables 1 and 2.
Some obvious comments about the solution are in order. If the formulation ignored
the existence of the subproblem's objective function, the master would act as a monopo-
list facing a fixed demand and thus could raise prices without limit. Also, the fact that the
subproblem has access to other supply sources is the driving force that controls the price
structure of the fertilizer dealer.

Multilevel vs other formulations

As is discussed above, many problems may be cast in the multilevel framework. How?
ever, in the past this has not been done extensively. This brings the question to mind:
what other approaches could be used? While not discussing this at length we can specu-


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J. Fortuny-Amat and B. McCarl?A Two-level Programming Problem

Table 1. The global optimum (prices per lb)

Shadow price of labour: y4 = 13.8150685.

late that either multiobjective programming or a procedure which ignores the subprob?
lem objective would be suggested as potentially useful. Now in the case of multiobjective
programming the objectives are generally weighted and optimized simultaneously.
Assuming for the moment this was done to the fertilizer problem above, we would
characterize our objective function as one in which the fertilizer dealer could be reason?
ably expected to sacrifice profit so that the farmer could obtain lower costs or the farmer
pay more than the minimum so that the dealer could obtain larger profits. Either of these
results clearly introduces irrational economic behaviour and in fact models the wrong
The formulation ignoring the subproblem's objective is a much more frequent type of
occurrence in the applied literature. Such models as energy minimizing models of the
U.S. economy would be an excellent example. Would U.S. industry sacrifice profitability
in order to minimize energy use? Candler and Townsley10 demonstrate the potential
error implicit in such an approach. Using a simple example problem, they solve the
master problem ignoring the subproblem's objective. This leads to 'optimal policy vari?
able settings'. The policy variable values are then plugged into the subproblem, and
optimal subproblem variables are found. Evaluating the master problem objective given
the optimal subproblem variables leads to an objective function value which is approxi?
mately 31% ofthe expected 'optimal value'. Thus, large errors are introduced by ignoring
subproblem structure. Solving the problem via multilevel programming, heuristics lead
to a solution with a master objective which is approximately 99% of the optimal value.


The paper has presented formulations from and a solution procedure applicable to the
area of multilevel programming. The solution procedure relies on stating the Kuhn-
Tucker conditions of the subproblem then using integer programming to accommodate
the complementary slackness conditions.
The one problem with this algorithm is the number of integer variables introduced in
the problem. In practice, subproblems are frequently large and would require many
integer variables. The authors feel that further research on an efficient solution of prob?
lem (PT) is desirable. Note that several other algorithmic procedures such as those based
on separable programming, quadratic programming coupled with Lagrangean relax?
ation, and complementary pivoting are possibly attractive for this problem, although
they have not been investigated.

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The authors wish to emphasize strongly that many problems are multilevel program?
ming problems and that improper formulations (such as those discussed above) may lead
to very incorrect results.

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Memorandum, DRC, World Bank, Washington, D.C.
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conservation policy. Unpublished Research Paper, Department of Industrial Engineering, Purdue University.
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Industrial Engineering, SUNY at Buffalo.
4M. Simaan and J. Cruz (1973) On the Stackelberg strategy in non-zero sum games. J. Optm. Theor. Appl. 11,
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Opns Res. 21, 37-44.
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the constraints. Opns Res. 22, 1097-1101.
8J. Bracken, J. Falk and J. McGill (1974) The equivalence of two mathematical programs with optimization
problems in the constraints. Opns Res. 22, 1100-1104.
9W. Candler and R. Townsley (1978) A linear multilevel programming problem. Unpublished Research
Memorandum, DRC, World Bank, Washington, D.C.
10Wilfred Candler and Robert Townsley. A linear two-level programming problem. World Bank,
Development Research Center Discussion paper No. 28.
nR. Cassidy, M. Kirby and W. Raike (1971) Efficient distribution of resources through three levels of
government. Mgmt Sci. 17, 473.
12F. Kydland
(1975) Hierarchical decomposition in linear economic models. Mgmt Sci 21, 1029-1039.
13J. Bard and J. Falk
(1979) An explicit solution to the multi-level programming problem. Serial T-388, 1979,
The George Washington University.


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