The Introduction of Risk into a Programming Model

Author(s): Rudolf J. Freund

Source: Econometrica, Vol. 24, No. 3 (Jul., 1956), pp. 253-263
Published by: The Econometric Society
Stable URL: http://www.jstor.org/stable/1911630
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THE INTRODUCTION OF RISK INTO A PROGRAMMING MODEL

BY

RUDOLF

J.

FREUND1

1. INTRODUCTION
CONSIDER

THE

linear programming problem:

to maximize s'x
subject to Tx
and

v
0.

One application of this problem is to let

s be a (column) vector of net revenues of unit levels of a set of productive
processes available to a firm,
x be a vector of the number of unit levels of each process in a productive
program,
T be a matrix of the amount of certain scarce resources needed by the unit
levels of the productive processes, and
v be a vector of available amounts of the scarce resources.
The linear programming problem then states that we wish to maximize net
revenue (s'x) subject to the restrictions that the amounts of scarce resources
used by a production program (Tx) do not exceed the available supply (v),
and that none of the processes can be carried out at negative levels (x > 0) [6].
We will here be concerned with the extension of this model to situations that
involve economic risk. It is conceivable that the method developed here can be
extended to more complicated cases such as monopoly programming [6, Ch. III],
or to other models that have been discussed in the literature (see [4], pp. 39-40),
but such extension will not be specified.
The development of risk programming will be divided into two steps:
(i) The description of a risk situation in a programming model, and
(ii) The method used to evaluate and choose from among risky alternatives.
The development will be straightforward and rather brief without any attempt
to compare the methods used with alternate ones. Such comparisons can be found
in [1] and [7].
2.

THE DESCRIPTION

OF A RISK

SITUATION

We will assume that the money outcome of a unit level of a process carried on
under risk conditions is in the form of a random variate which follows some
probability distribution. This distribution can be defined as representing some
measure of the degree of belief that particular outcomes will occur. This degree
of belief is, of course, a highly subjective concept, but it is conceivable that
1 This paper is based on a thesis presented to North Carolina State College, June, 1955.
The author wishes to acknowledge the help of Clifford Hildreth whose ideas form the background for a large part of this work.
253
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254

RUDOLF

J.

FREUND

it may be evaluated from observed actions of individuals [12]. We will assume

that the probabilities of particular events depend upon the past experience of
the entrepreneur.
This probability distribution of net revenue of a unit level of a process can be
developed from practically any assumptions about the distribution of the various
components that enter into net revenue. Thus, for example, one may consider
that only the prices of the outputs of the process are subject to random fluctuations while all quantities and prices of inputs are at fixed, known levels. For
practical purposes it is, however, easier to consider the net revenue of the unit
level as the random variate under consideration and obtain the probability distribution from this variate than it is to obtain the distributions of the various
factors that go into the net revenue and then to attempt to combine these into a
distribution of net revenue. This latter procedure may lead to very difficult
distribution problems which may tend to obscure the primary purpose of the
programming problem.
It will here be assumed that the elements of T are not subject to random
fluctuation. Methods to handle this situation are suggested by Babbar [2] and
Tintner [13].
From the distributions of the net revenue of the unit levels of the various
processes one can develop a distribution of the net revenue due to some program
x. If the net revenue of each process is assumed to be normally distributed:

s,:N(,u,,

oa2)

with the covariance between the net revenue of two processes defined as ?j,
then the net revenue, r, will also be normally distributed:

r:N(,u'x,X'2;X),
where 2 is the matrix of variances and covariances of the si. Of course, it is
possible to assume any other distribution of the si, but due to the distribution
problems posed by the use of most other distributions and the lack of data either
to support or reject any assumed distribution the normal will be used in the
development of a risk program.
There does, however, exist one alternative to the assumption of a normal
distribution; this consists of the use of a discrete distribution. Thus, it is assumed
that a particular combination of unit level net revenues, say
(s

)I

(Si t)

S2

t)

. . .

s( t)

t =

l1t

2,

has a probability, pt, say. The probability distribution of net revenue due to a
program x can then be defined:
Pr(r Ix) = p((sPt))'x).
This formulation of the probability of net revenue will be used in an alternative
development of a risk program.
One feature of both methods of describing an uncertain outcome is that they
depend on the decision variable, the program x. Thus the entrepreneur making a
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255

MODEL

A PROGRAMMING

decision about x must choose from among a set of probability distributions; the
number of distributions in the set is governed by the various possible values of x.
3.

THE EVALUATION

OF RISKY

ALTERNATIVES

The evaluation and consequent choice from among a set of probability distributions will here be accomplished by the use of the expected utility hypothesis
[3, 11]. According to this theory an entrepreneur behaves as though he places
some numerical utility, invariant through transformation of origin and unit of
scale, on each certain outcome and then acts to choose that probability distribution which exhibits the maximum (mathematical) expected utility.
In the case under discussion here, the outcomes are all in terms of net revenues.
Thus the utility of certain outcomes is equivalent to the utility of net revenue,
or the utility of money; the relationship between the outcomes and their utilities
becomes the utility of money function. In general this utility function describes
the nature of the entrepreneur, i.e., whether he is a gambler or whether he is
conservative, and how extreme is his inclination toward either of these characteristics [8].
One such utility function which we will find convenient to use is
y (r) - 1

where y is the utility and r is the net revenue. This function is convex everywhere
and indicates a conservative entrepreneur. The constant a indicates the entrepreneur's aversion to risk; the larger the value of a, the more conservative the
entrepreneur. If we now assume that net revenue is normally distributed, the
maximization of expected utility
E(u)

(1 -_ C)

e(r

)2/2a2

dr

is easily shown to be accomplished if we maximize the function2

E(u*) = -,-

a .

Remembering the form of the parameters of the distribution of the net revenue
in a programming model, the maximization of expected utility can be accomplished by maximizing

E(u*)3-s'x

2a ,x

subject, of course, to the usual restrictions, viz.:

Tx ( v,
2

This is accomplishedby completingthe square in the exponent which producesa

normal integral multiplied by - exp [(a2o-2/2) - a,pl. Since the integral becomes a constant, the maximization of E(u) is equivalent to minimizing the exponent which is in turn
accomplished

by maximizing I

(a/2)cr2.

The suggestion that a convenient expression to be maximized could be obtained under

these assumptions was originally made_byC. G. Hildreth.
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256

RUDOLF

J. FREUND

and
x > 0.

This is now a problem in quadratic programming [6, Ch. III] and [10], for which
a solution procedure has not yet been completely perfected. In the next section a
short computational example is presented and in the appendix there is an explanation of the procedure used and an attempt to show that this is an optimum
solution.
It was pointed out above that we can assume a nonparametric (discrete) distribution of the vector s. If we let s be a random variate and assume the utility
of money function
y(r) = r

br2

then the expected utility of a program x is

E(u I x) = E(s)'x

bx'E(ss')x,

where
E(s) = , Pr(s())s(t
and

E(s8') =EPr(S('I)P)S(ts'
The maximization of expected utility in the programming model is now also a
quadratic programming problem, viz.
to maximize E(u Ix)
subject to
and

Tx
x

<

dx'

bxFx'

v
O,

where d is the expression for E(s) and F is the quadratic form for E(ss').
The use of a quadratic utility function of money needs some clarification.
In the normal case this would not be an acceptable function as a quadratic has
a negative slope in some region where there exists a probability of r. In the discrete case, however, this region can be made to be outside the realm of possibility, i.e., in a region where the probability of r is zero.
4.

A COMPUTATIONAL

EXAMPLE

We will be concerned with finding an optimum combination of crops for a

representative Eastern North Carolina farm. The problem presented is only a
part of a more comprehensive program; limitations of computational facilities
force the reduction.
The matrix T of the unit level scarce resources, the vector s of unit level net
revenues, and the vector v of scarce resource limitations are presented in Table
I. The derivation of these figures is more fully discussed in [7]. The resulting
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A PROGRAMMING

257

MODEL

TABLE I
THE MATRIXOF UNIT LEVELRESOURCE
REQUIREMENTS
Amounts needed by unit level of process
Scarce
resources___________
Scarce
resources
1
Early Irish
potatoes

Land, acres
January-June
July-December
Production Capital, $100
Period 1 (Jan.-April)
Period 2 (May-Aug.)
Period 3 (Sept.-Dec.)
Managerial labor, hours
Period 1
Period 2
Period 3
Unit level profit $100

4
Fall Cabbage

Availability
resources of

2
Corn

3
Beef

1.199
.000

1.382
1.382

2.776
2.776

.000
.482

60.
60.

1.064
-2.064
-2.064

.484
.020
-1.504

.038
.107
-1.145

.000
.229
-1.229

24.
12.
0.

5.276
2.158
.000

4.836
4.561
4.146

.000
.000
.000

.000
4.198
13.606

799.
867.
783.

1.000

1.000

1.000

1.000

TABLE II
THE OPTIMuM PROGRAM
Process

1.
2.
3.
4.

Potatoes .22.14
Corn..00
Beef (pasture) .11.62
Fall cabbage.57.55

Unit Levels

Acres

26.55
.00
32.26
27.74

Net Revenue ($100).91.31

optimum (no-risk) program as obtained by the simplex procedure is given in

Table II.
An interesting feature of this program is its heavy reliance on the relatively
high risk crops of potatoes and fall cabbage, and its complete bypassing of corn
which is one of the main crops of the region. The reason for this is that the high
risk crops are quite profitable in the long run, but most farmers are neither
willing nor able to endure the extreme fluctuations of the net revenue of such
crops. It is for this reason that the development of a risk programming procedure appears to be of some importance.
The problem of finding an optimum combination of crops for a representative Eastern North Carolina farm will now be extended to include risk by
using the expected utility hypothesis, assuming that the si are normally distributed, si:N($100, a2) and Cov. sisji = ij, and that the entrepreneur's utilityof-money function is 1 - ear. In addition to the data already presented there
is need for the matrix Z, the matrix of variances and covariances of unit level
net revenues and the risk aversion constant a.
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258

RUDOLF

J. FREUND

Ideally the variances (and covariances) of the unit level net revenues should
measure the variabilities in the net revenue of these processes under conditions
of constant price levels and constant managerial practices. Since such data are
not only difficult to obtain, but are also unavailable for the type of farm which
is being analysed, approximate procedures have been used to obtain estimates
of the elements of the matrix M.First, it was assumed that only prices and yields
of the outputs are random variates; prices and quantities of all inputs, such as
fertilizer, tractor costs, etc., are assumed fixed at given levels. This assumption
is not unreasonable for the type of farm we are considering here, but would not be
realistic for a corn-hog farm, for example, where the input, corn, certainly will be
subject to price fluctuations. Secondly, prices and yields used to obtain estimates
of past unit level net revenues consisted of adjusted state averages. These past
unit level revenue estimates were used to obtain the variance-covariance matrix 2.
The main disadvantage of the use of state averages is that it definitely underestimates the variance since the basic data are already averages. This is especially
serious in the case of the yields where, especially due to the irregular pattern of
summer storms, the individual farm variabilities are averaged out over larger
areas. Some limited data were examined which indicated that the ratio of farm
variances to state average variances of yields may be as much as three or four
to one.
The estimation of the risk aversion constant a is a purely subjective task,
and any chosen value is exceedingly difficult to defend. It would seem to this
author that for a farm of the size of the one in this article, a value somewhere
between 1/2500 and 1/5000 is reasonable. However, to adjust for the fact that
the variances were underestimated, a value of 1/1250 was used for a.
The unit level variance covariance matrix, 2, is presented in Table III. The
quadratic programming problem:
to maximize s'x

2 x'Ex

subject to Tx < v
and

x > 0

was solved by the use of the Kuhn and Tucker [10] minimax theorem and a
solution procedure developed by Hildreth [9]. The procedure is more explicitly
presented in the Appendix.
TABLE III
UNIT LEVEL VARIANCE-COVARIANCE MATRIX
Crop

Potatoes ............
Corn
Beef
Fall Cabbage ........

Potatoes

Corn

Beef

Fall Cabbage

7304.69

903.89
620.16

-688.73
-471.14
1124.64

-1862.05
110.43
750.69
3689.53

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259

MODEL

A PROGRAMMING

TABLE IV
COMPARING THIE RISK AND THE NO-RISK
Item

OPTIMUM PROGRAMS
Risk Program

No-Risk Program

10.31
26.75
2.68
32.35

22.14
.00
11.62
57.54

12.36
36.97
7.44
15.59
7209
5369
1517

26.55
.00
32.36
27.73
9131
4393
2434

Process Intensities
Unit levels
Potatoes
Corn
Beef
Fall cabbage
Acres
Potatoes
Corn
Beef
Fall cabbage
Expected net revenue, dollars
Expected utility, arbitrary units
Standard deviation of net revenue, dollars

The resulting optimum risk program is presented in Table IV. The no-risk
program is given alongside for comparison. The results are about what were to
be expected. The contribution to the total net revenue of the high risk crops of
potatoes and cabbage was reduced from 87.3% to 59.2%, in addition to which
more "safety" is achieved by the fact that the total net revenue does not depend
largely on a single crop. It is true that the net revenue has been decreased, but
so has the standard deviation of net revenue. It may be argued that the reduction
in the standard deviation was bought at a rather large expense in net revenue;
this is due to the fact that the risk aversion constant a was given a rather high
value to counter the expected underestimation of the variances.
The quadratic programming procedure used produces a set of imputed prices
to the limited resources similar to those produced in the linear programming
procedure ([6], Ch. H, section 6, and Ch. III, section 4). These imputed prices
TABLE V
IMPUTED PRICES OF THE RISK AND NO-RISK
Risk Program

PROGRAMS
No-Risk Program

Item
Imputed Prices in Dollars

Land, acres
Spring
Fall
Production Capital $100
Period 1
Period 2
Managerial Labor, hours
Period 1
Period 2
Period 3

.00
32.93

.00
34.74

65.96
.00

94.01
.00

.00
.00
.00

.00
.00
6.10

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260

RUDOLF

J. FREUND

differ from those in the linear case in that the total imputed cost, sum of the
products of the imputed prices and the quantities used is less than the total net
revenue. The imputed prices do, however, indicate by what amount the function
to be maximized can be increased by increasing the supply of a scarce resource.
In the risk programming model, an increase in the function to be maximized will
be in dollar terms. This occurs since an increase in the function
y =

2
&-

ao

can be accomplished by increasing the expected revenue, ,u, while keeping a2

constant. The imputed prices of the scarce resources for both the risk and no-risk
programs are given in Table V.
The imputed prices show no radical changes; the same resources stay "valuable," except that third period labor is no longer of any value. This is due entirely
to the reduction in fall cabbage.
5. SUMMARY

The introduction of risk into an economic model of a firm and consequently

into a linear programming model of a firm has been accomplished by describing
risky outcomes as probability distributions and choosing from among alternate
possible distributions by the expected utility hypothesis.
Two basic weaknesses have appeared in applying this method of incorporating
risk. One difficulty arises in choosing a value for the constant a, which in this
case is some sort of risk aversion indicator, and is, to some degree, governed by
personal characteristics of the entrepreneur. A large value for a indicates that
the entrepreneur places great weight on the variance as a deciding factor and is
consequently highly adverse to risk, and vice versa. The estimation of such a
constant to be used in a model is thus quite important; the wrong choice will
invalidate any results obtained. The derivation of this constant is a delicate task
beyond the scope of this paper.
The second weakness of this method comes in the evaluation of the variances
of net revenue. In a programming model we are interested in obtaining the entrepreneur's own estimate of the variability of prices and yields of individual crops.
Such estimates, if obtainable, would be based on his observations of past performances and would presumably be deflated, in the entrepreneur's mind, to
constant dollars and constant entrepreneurial practices. Some attempt was made
to obtain such data, but it met with dismal failure, not only because of incomplete memory, but also because the farmer had not had experience with some of
the crops that were of interest for the programming analysis. The best approximation to this data should be obtainable from farm records, especially such
records that include data on entrepreneurial practices that may create changes
in expected yields. As more refined data are developed, the assumptions made
here as to the form of the utility and net revenue functions should be tested.
The procedure for introducing risk developed in this paper can probably be
extended. The analysis should be useful for ascertaining the effects of government
programs that reduce risk of growing certain crops, in preparing price maps,
etc. It should also not be too difficult to incorporate risk into monopoly or regional
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261

MODEL

A PROGRAMMING

programming as presented by Dorfman. Finally, it would be interesting to see if

the method of incorporating risk proposed in this study can be used in programming models other than the one we have discussed.
The limited work that has been done in this study does, however, show that
the method proposed will result in an optimum program that shows less "risky"
features than does the no-risk linear program. The plausibility of this outcome
is encouraging for the potential usefulness of the procedure, even though many
questions are yet to be answered.
Virginia Polytechnic Institute and
North Carolina State College
APPENDIX
COMPUTATION

OF A QUADRATIC

PROGRAMMING

PROBLEM

Computational methods for quadratic programming have not yet been completely
developed. One method is described below and it is shown that the resulting solution is
indeed optimum. One other method, suggested by Charnes and Lemke [5], approximates
curved lines of separable quadratic or other convex nonlinear functions by series of connected straight line segments, whence the problem is solved by linear programming techniques.
Kuhn and Tucker [10] proved that the quadratic programming problem
to maximize s'x

x'Ex

subject to Tx < v
is equivalent to the minimax problem
maximize with respect to xlx)
minimize with respect to uf

subject to u > 0,
where u is a vector containing as many elements as T has rows.
This is not identical with the quadratic programming for the risk problem which is to

maximizes'x

subject to Tx < v
and x > 0.
Some redefinitions will, however make the risk programming problem amenable to the
minimax approach. First let %aS becomeE* and then define

T*=(

I)'

and v*=(0

where -I is negative identity matrix and 0 is a vector of zeros; T* and v* have the same
number of rows. Then, the risk programming problem can be stated
maximize s'x -x'*x
subject to T*x 6 v*,

which can be converted into a minimax problem.

Hildreth [9] has suggested a procedure for solving this minimax problem. He has, howThis content downloaded from 143.106.81.78 on Mon, 14 Sep 2015 15:12:15 UTC
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262

RUDOLF

J. FREUND

ever, only proved the procedure for cases where the matrix T (or T*) is of full row rank.
In the risk programming problem, however, the matrix T* cannot be of full row rank due
to the fact that the negative identity matrix forces T* to have more rows than columns.
The procedure is quite adequately presented in Hildreth's paper, whence the presentation here will be quite brief and will serve only to facilitate the exposition of the method
used to check the optimality of the solution obtained. The minimax problem is
maximize with respect to x

ux
4+(x, u)

minimize with respect to u

s'x -x'Z*'

+ 4'(v -T*x)

subject to u > 0.
Since the maximization with respect to x is unrestricted, this can be accomplished by taking
the derivative, setting it equal to zero and substituting back. The problem then remaining
is
minimize with respect to u: +*(u)

b'u + u'Cu

subject to u > 0,
where
kc =

b' = V'-

he*ts

*-1 T*'

and
C

= T*E*-l

T*'.

The vector u which accomplishes this minimization is found by an iterative procedure.

The difference between the quadratic programming problem and the problem discussed
by Hildreth becomes obvious at this stage. If the matrix T* were of full row rank, then,
assuming that * is positive definite, the matrix C is also positive definite. If T* is not
of full row rank, then C is only positive semi-definite. The difference is thus that Hildreth
obtains the restricted minimum of a positive definite quadratic form while the solution of
the quadratic programming problem requires the restricted minimum of a positive semidefinite quadratic form. Obviously a positive semi-definite quadratic has no (unique)
minimum, but under certain restrictions such a unique minimum could exist. Thus a theorem that states that the restriction of a quadratic programming problem transforms into
those restrictions that provide a unique minimum of the positive semi-definite quadratic
form would show that quadratic programmingproblems can be solved by the Kuhn-TuckerHildreth procedure.
Lacking a proof of this theorem, it can be shown that a solution to a quadratic programming problem obtained by this procedure is an optimum solution. Dorfman [6] shows
that the number of scarce resources (or effective restrictions) in an optimum (quadratic)
program is less than or equal to the number of active processes and thus less than or equal
to the total number of processes. Thus, if only those restrictions actually effective in an
optimum solution are included in T*, it will be of full row rank whence a solution to the
problem can be obtained. In addition, the mechanics of the Kuhn-Tucker-Hildreth procedure can still be performed on a quadratic programming problem, i.e., one where T* is
not of full row rank, and limited experience has shown that the procedure does converge
to a solution.
The procedure used to show that a solution is optimal thus becomes rather obvious. A
solution to the general quadratic programming problem is obtained by the mechanics of
the Kuhn-Tucker-Hildreth procedure. The information obtained is then used to construct a reduced T* matrix which includes the effective restrictions. This reduced matrix
is then used to obtain a solution which is obviously optimal. If the solutions to the two
problems are identical, it can be assumed that an optimum solution has been obtained.
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A PROGRAMMING

MODEL

263

This procedure was used to check the optimality of the risk program in the text. In the
solution, only two restrictions were found to be effective: Fall land and period 1 capital.
Since there are four active processes, the T* matrix will be of full row rank with up to four
restrictions. Thus two more restrictions, those of spring land and nonnegativity of the
beef process were added, more or less as a check. The procedure used followed directly the
outline by Hildreth [9], and the results were identical with those obtained by the original,
nine-restriction problem, whence we can assume that the solution is optimal.
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[21 BABBAR, M. M.: "Distributions of Solutions of a Set of Linear Equations," Journal
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[31 BERNOULLI, D.: "Specimen theoriae novae de mensura sortis," Commentariiacademiae
scientiarium imperiales Petropolitanae, 5, 175-192. Translated by Dr. Louise Sommer, Econometrica,22 (1954), 23-36.
[4] CHARNES, A., W. W. COOPER, AND A. HENDERSON: An Introductionto Linear Programming. New York: John Wiley and Sons, Inc., 1953.
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[61 DORFMAN, ROBERT: Application of Linear Programming to the Theory of the Firm.
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[7] FREUND, R. J.: "The Introduction of Risk into a Linear Programming Model," unpublished thesis, North Carolina State College, 1955.
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[13] TINTNER, GERHARD: Stochastic Linear Programming. Second Symposium on Linear

Programming, National Bureau of Standards, Washington, D. C., 1 (1955), 197227.

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