MANAGEMENT SCIENCE

Vol. 24, No. 4, DMmber 1977

U.SA.

FACILITY LOCATION WITH PRICE-SENSITIVE

DEMANDS: PRIVATE, PUBLIC, AND QUASI-PUBLIC*
DONALD ERLENKOTTERf
We formulate a general model for an uncapacitated facility location problem in which
demands are related to the prices established at the various locations. Pricing decisions and
location decisions are determined simultaneously in this model, in contrast to traditional
location models that assume fixed demands and prices. We show that a transformation of the
general model is equivalent to the fixed-demand location model of Efroymson and Ray, and
thus may be solved by any of the exact or heuristic methods available for that model.
Specifying either a private sector objective of maximizing profits or a public sector
objective of maximizing net social benefits provides a particular case of the general model. A
third plausible objective is Ihe "quasi-public" one of maximizing net social benefits subject to
a constraint that ensures sufficient revenues to cover costs. A Lagrangian relaxation of this
constraint, which yields another case of the general model, is used to develop a solution
procedure for the quasi-public objective. Details of the solution approach are given for
quadratic revenue functions, and an example illustrates the procedure.

1. Introduction
Static models for facility location typically assume that facilities are to be estab-
lished to meet fixed demands, specified by location, at minimum total cost. The
possibility that demands may be influenced by pricing is excluded. Even the survey of
ReVelle, Marks and Liebman [14], which presents both private and public sector
location models and discusses more general objectives, provides specific models only
for fixed demands.
A notable exception is a recent paper by Wagner and Falkson [18], who define
price-sensitive demand relationships at various locations and then jointly determine
pricing and location decisions under a public-sector objective of maximizing net social
benefits. Wagner and Falkson show that their model can be transformed into one
equivalent to the fixed-demand model of Efroymson and Ray [4] and thus solved by
exact [4], [5], [11] or approximate [3J, [12] approaches for that model.' Hansen and
Thisse [9] have developed a similar model and approach for the private-sector
objective of profit maximization.
Here we develop a general pricing-location model that includes those of [9] and [18]
as particular cases. This general model also can be solved through an equivalent
fixed-demand formulation. We then examine a third situation; a "quasi-public"
enterprise of the type discussed in [2] and [13] that desires to maximize net social
benefits subject to a constraint ensuring sufficient revenues to cover costs. Without
such a constraint, a solution for the net social benefits objective always entails a loss
and would be unacceptable for those public and not-for-profit organizations that are
required to be self-supporting, A Lagrangian relaxation of the constraint provides
another case of the general model. We develop a solution procedure for the quasi-
public situation that solves a sequence of equivalent fixed-demand problems defined
through the Lagrangian relaxation. An example illustrates the procedure and the
implications of adopting a private, public, or qtiasi-public objective.
* Accepted by Peter J. Kolesar; received June, 1976. This paper has been with the author 4 months, for 2
revisions.
* University of California, Los Angeles.
' The most powerful of these approaches [S] has obtained and verified optimal solutions to several
problems with 100 potential facility locations and 100 demand locations in less than a second each on an
IBM 360/91 computer. Computability, therefore, would not seem to be a major obstacle in most
applications of this model.
378
Capynghl "O 1977, The Institute of Management Sciences
 FACILITY LOCATION WITH PRICE-SENSITIVE DEMANDS 379

2. The General Lx>cation-Deniand Model

The Efroymson-Ray model for uncapacitated facility location with fixed de-
mands [4] indexes potential facility locations / = 1, 2, . . . , ?3 and demand locations
y == 1, 2,. . . , n, and requires the following notation: x^j is the fraction of location/s
demand supplied from facility /; V/ is 1 if facility ; is established and 0 otherwise; c,-^ is
the total of variable capacity, production, and distribution costs for supplying all of
locationy"s demand from facility /; a n d / > 0 is the fixed cost for establishing facility
i. The formulation of this model is:

Minimize 2 2 ^//^ + 2 Ay/

subject to
2x,j=U y = l,2, . . . , n , ("F^

2 ^ y < ny,; i = 1,. . . , w,

j
all.x,^. >0,>', E{0, 1}.
As Efroymscn and Ray show, there is an optimal solution in which each demand is
supplied from a single source that has minimum c,y among the open facilities. Thus the
x,j are integer-valued also.
To obtain a model that determines both location decisions and demand levels, we
define the following: the number of potential facility locations is m l;y, a n d / are
as above; s is the quantity provided from / toy; D is the demand atj; B(D) is the
total benefit a t / associated with demand amount D ; t > 0 is the variable capacity,
production, and distribution cost per unit of demand aty supplied from f, and Af is a
large positive number. The benefit functions fly(-) are assumed to be concave,
differentiable, and bounded above, with (^(0)'=0. The formulation of the general
location-demand model is then:

Maximize S B,{Dj) - ^ 2 '.A " 2 fji

subject to

2 % < My,; / = 1, 2, .. . , m - I,
j
O,,v, e{0, 1}.
As Samuelson has observed for his related spatial model [15, p. 294], solution of a
minimum-cost problem in the form of (F) is a necessary condition for optimality
given any fixed values for the demands D in problem (G). In particular, this must be
true for the optimal choices D*. Therefore from (F) we know that each demand will
be supplied from a single source.
We now may determine as in [9] or [18] potential optimal demand quantities under
the presumption that they will be supplied from a single source. Let D^ be the optimal
demand quantity for ; if supplied from /. The values for D*j are determined by
equating marginal benefits and marginal costs in (G):

(1)
380 DONALD ERLENKOTTER

An equivalent problem to (G) is then:

Maximize 2 1 [BjiD*) - l,jD^]xy - 2 fj>,

subject t o
S-^iy < I; ; = 1,2, . . . , / ! ,

2-<(,</iy,; / " 1, 2, . . . , / M - 1 ,

where all X/ in an optimal solution will be 0 or 1 as in (F). To place the formulation

(G') in the form of (F), we define Cy == -[B^(D0 - t^jD*] and add a dummy (or slack)
source indexed m with c^ = 0 andf^ = 0 to convert the first set of constraints in (G')
to equalities. Thus any general problem of type (G) may be solved by approaches
available for problem (F).

3. Private, Public, and Quasi-Pubiic Objectives

By adding detail to the benefit functions Bj(-) in the general model (G), we obtain
various specific models. Assuming an identical pries p(Dj) for each unit of demand at
location/, the total revenue Rjii>j) from/ is defined by RJ{DJ) ='pj(Dj)-DJ. Provided
that RjiDj) satisfies the conditions specified above for Bj(Dj), we may replace Bj(Dj)
in (G) by RADj) to obtain the profit-maximization model of Hansen and Thisse [9].
For the second pricing-output case in (1), we have
dRj{DI)/dD,'o.t,j, (2)
the monopoly rule of setting marginal revenue equal to marginal cost.
To obtain the public-sector model of Wagner and Falkson [18], we construct the net
social benefits objective by adding to profits the additional net benefits accruing to
consumers from receiving a price lower than the maximum they would be willing to
pay (I I, pp. 497-500], [iO, pp. i9O-193]). Suppose the actual price charged aty is
Pj{Dj), corresponding to the total quantity >. For the incremental unit added to a
demand of TJ < >, this "willingness-to-pay" is the price Pjiri) and the net benefit to
the consumer is the price difference/),(TJ) - Pj(Dj)- The total "consumers' surplus," or
net benefits summed over all units of demand from 0 to Dj, is given by

Total social benefits from j are defined as

j% (3)
the area under the inverse demand curve pX) on the interval (0, Dj]. If each price
Pj{Dj) is continuous and nonincreasing in D- and becomes 0 for a finite value of D,,
total social benefits in (3) may be substituted for BAD) in problem (G). For this
public sector objective, the pricing-output rule from (1) becomes

the standard economic efficiency criterion of setting price equal to marginal cost.
From (4), we see the possible dilemma posed by the net social benefit objective:
multiplying both sides of (4) by optimal values of xf. D^ and summing over all / and/
 FACILITY LOCATION WITH PRICE-SENSITIVE DEMANDS 381

reveals that total revenues are equal to the total of costs variable with demands. No
revenue contribution is obtained toward the total fixed facility cost ^Jjy*.
To ensure that revenues are sufficient to cover costs, we may add to (G) the
constraint

S^y(^y)-2?Vi.-2A>',>0, (5)
J I J '
which excludes negative profits. A solution for the net social benefit objective and this
constraint can always be obtained since the null solution with all /, = 0 is feasible.
The constraint (5) will hold with equality in the optimal solution since for fixed/, the
formulation (G) is a continuous concave problem and the unconstrained solution
violates (5). If desired, we could specify a positive minimum profit level in (5), but a
feasible solution could not be guaranteed.
The formulation (G) with (5) added is a nonlinearly constrained, mixed integer
problem with a nonlinear objective and would appear to be difficult to solve directly.
A single source will still supply each demand in the optimal solution since, with the Dj
fixed, (5) sets an upper bound on the objective for the cost minimization problem and
can be ignored. But (5) interferes with the determination of potential optimal
quantities D^, and the transformation to formulation (G') cannot be accomplished
directly.
To provide a workable solution approach for the profit-constrained quasi-public
location problem, we employ a Lagrangian relaxation [6), [8] of the constraint (5). The
relaxed objective function for (G) becomes

\ A (6)
where A > 0 is the multiplier for constraint (5). Given the specifications for pADj) and
Rj(D) above, (6) is concave. Let V(X) denote the optimal objective value for (G) with
objective (6). V(X) is an upper bound for the objective value of (G) with benefits
defined by (3) and constraint (5) added. If \ can be chosen such that the solution
corresponding to V(X) satisfies constraint (5) with equality, the solution is also optimal
for the constrained problem. If not, a "duality gap" [6], [8] is present. We show in the
following section how to resolve such gaps and obtain a solution to the constrained
problem in all cases.
A more revealing way of viewing the Lagrangian objective is to divide (6) by 1 -1- \
and substitute 0 < a = 1/(1 + A) < 1, giving the alternate form

2 [a[S/Dj)+RjiD^)]+il - a)Rj{D^)] - 2 2 V v " ^/cV,- (7)

y I J

A weighted combination of social benefits (with weight a) and revenues (with weight
1 - a) has replaced the general benefit term Bj(Dj) in (G). The tradeoff rate between
social benefits and revenues is a/(I - a). For a = 1 in (7), we obtain the public sector
model; for a = 0, we have the private sector case.
Using this weighted combination, the reformulation (G') follows directly, with
optimal potential demands determined as in the second case of (1) by

P,(A|) + (1 - a)dRj{D*)/dDj t,j. (8)

A weighted average of price and marginal revenue is set equal to marginal cost, and
the weights are identical for each demand location j . For other economic interpreta-
tions of the rule in (8), see [2] and [13].
382 DONALD ERLENKOTTER

4. Solution Procedures for the Qiusi-iPublic Case

To obtain a solution to the profit-constrained, quasi-public case, we could try
different values of a, solving formulation (C) for each a and checking the sign of the
profit term. A numerical procedure such as bisection [7] might accelerate convergence
to a zero-profit solution. But this process could be tedious since each solution of (G)
addresses an entire location problem. If a duality gap is encountered, we will have to
continue the search process further as described below.
Finding a zero-profit solution for fixed values of the integer variables;^, by varying
a is easier since a simple concave problem with continuous variables is defined.
Similarly, finding an a that equates the objective value for a pair of ^, solutions is
relatively easy. In particular, for the case of quadratic revenue functions we can
obtain analytical solutions to these two simpler problems. We will show how these
solutions can be incorporated into a general procedure.
The core of the procedure is to pick a value for a, solve for the optimal/,, and then
find the value o that yields a zero-profit solution for the y^. This procedure is repeated
with the new value for a. Each time a new set of / , is discovered, bounds on the
overall zero-profit value for a are tightened. If a solution >, should reoccur, a new
value of a is obtained by equating objective values for two extreme sets of /,. The
procedure terminates with either a zero-profit solution or a duality gap. If a gap
occurs, we initiate a branch-and-bound process and repeat the procedure for the
subproblem on each branch.
To formalize this procedure, we define: /= {/ :>',== 1}; fi(/, a) is the optimal
objective value as in (7) for / and a; n(/, a) is the corresponding profit level as in the
left-hand side of (5); a" and a* are lower and upper bounds on the overall
zero-profit solution for a in (G) with objective (7), and / ~ and / * are the optimal
open-facility sets corresponding to a" and a*. To avoid trivialities, we assume that a
positive-profit solution exists and that an initial value ag (e.g.. OQ 0) with positive
profit is chosen to eliminate a separate initialization procedure for / " and / * . The
steps of the procedure are:
Step 1. Initialize /c 0, a" 0, and a* = 1. Select an initial trial value a,,.
Step 2. Find an optimal solution to (G') for a^., yielding an optimal open-facility
set 4 . If 4_i is also optimal for a^, set /^ = 4 _ , .
Step 3. If:
(a) 11(4, "*) * ^' ^^^'P *i^'^ optimal zero-profit solution.
(b) n ( 4 , a^)> 0, set a~ a,^ and I" =" Ii,.
(c) n ( 4 , a,^) < 0, set a* = a^ and /"^ 4 .
Step 4. If a nonnegative profit solution for 4 does not exist, set a ' = -00.
Otherwise, find a' such that 11(4, ') " 0-
Step 5. If a' ]a~, a"*" [, increase k by 1 and return to Step 2 with a^. = a'.
Step(). Find a * E [ a ~ , * } such that $2(7", a*) = Q(/"^, a*). Find an optimal
solution to (G') for a*, yielding 7*. If 7 ~ and 7 * are also optimal for a*, stop with a
duality gap solution. Otherwise, increase A: by 1 and return to Step 3 with ^ = a* and
/*/
In Step 4, we always obtain a' < 1 since a = 1 yields negative profits for all 7 # 0 .
If a nonnegative profit solution is possible for 7, continuity ensures existence of a
zero-profit solution. In Step 6, continuity also ensures that a solution a* E [a~, a"^ |
can be found. If termination occurs with a duality gap, we have 11(7 ~, a*) > 0 and
n ( / * , a * ) < 0 since the procedure determines a~ and a'^ such that 1~{I*) has
positive (negative) profits in Step 6 for all a E]o~, a"*" [. If the choices for a' and a*
are finite, as in the quadratic revenue case of the next section, the procedure is finite
since each return from Steps 5 or 6 eliminates one or more of the remiaining choices.
 FACILITY LOCATION WITH PRICE-SENSITIVE DEMANDS 383

If the procedure terminates with a duality gap for I ~, I*, and a*, we may initiate a
branch-and-bound process to resolve the gap. Selecting a variable / , equal to 0 in
/ " (/ *) and 1 in / * ( / " " ) , we create two subproblems, one with the constraint7, 0
and the other with/, = 1. The first subproblem eliminates /*" ( / ~ ) as an alternate
solution for a*, and the second eliminates / ~ (/ "^). We now repeat the above search
procedure for each subproblem. The procedure may begin with OQ = a* provided that
initialization of a positive-profit solution / ~ is ensured.
If a duality gap occurs in a subproblem, we continue branching if the subproblem
cannot be eliminated by bounding. An upper bound on net social benefits with zero
profits is provided by the value of the Lagrangian relaxation objective from (6),
calculated here as 2(1', a*)/a* = B(/+, a*)/a*. A lower bound is given by the best
zero-profit solution obtained in Step 4 of the procedure.
Although we have specified an optimal solution for formulation (G') in Steps 2 and
6 of the procedure, less effort might be expended if heuristic solution approaches such
as those of [31 or [12] were used to locate an approximate final value for a. The exact
procedure would then be activated from this approximate value, possibly reducing the
number of complete solutions of formulation (G') required.

5. A Quadratic Revenue Example

To illustrate the solution of the quasi-public facility location problem, we give
details for the case of quadratic revenue functions and provide an example. In the
quadratic revenue case, we have pj(Dj) = a, - b^Dj, where at, > 0 and bj > 0, and
RX^j) = (ijl^j ~ ^/^/- This type of price specification is prominent in spatial equi-
liljrium models [16], [17].
For optimal potential demands, we apply conditions (I) and (8) for the quadratic
revenue definition to obtain

/),'-(2-a)-V*,. (9)
where 6^ = max{Oy - r^., 0}. Given the set of open facilities /, the actual demand is
determined by 8.j = max,g^5,-^, which selects the location with minimum variable cost.
The profit term ri(/, a) as in (5) may be derived as

JbrZJv (10)
The weighted benefit function Q(I, a) from (7) is given by

, a) = 0.5(2 - )-' Sfi.y*,- S fr (11)

J ier
Also useful for comparing solutions is the total consumers' surplus associated with /
and a, derived from (3) as

2 2S,(A?K;-0.5(2-a)
(/ J

Total net social benefits for a and open facility set / are obtained as the sum of profits
in (10) and consumers' surplus in (12).
Now we can see the simplicity for this particular case of finding zero-profit
solutions in Step 4 and equal objective value solutions in Step 6 of the procedure
outlined earlier. To find a zero-profit solution for /, we check first that nonnegative
profits are possible. Since a = 0 yields the profit maximum, we see from (10) that
^j8y/bj > 4 2,e//- is required. If this test is passed, finding a' to set U{I, a) 0
 384 DONALD ERLENKOTTER

requires solution of a quadratic equation in a. To find a* such that 0(7", a*)

- fl(7*, a*), from (11) we obtain an equation that is linear in a.
Data for an example problem with four demand locations and four potential
facihty locations are given in Table 1. To show how the location solution is influenced
by the specification of a. Table 2 gives various optimal facility combinations and the
corresponding range of a over which the solution remains optimal for the Lagrangian
objective. The evolution of the solution procedure for this example is as follows:
Step I. ft: = O, - = 0 , a* = 1, ao = O.
Step 2. ao=* 7o =- {3}, n(7o, ap) > 0.
Step 3. a~ 0 , 7~ {3}.
Step 4. n(7o, a') = 0 => a' = 0.910.
Steps. a'ElO, l[=*it= l,a,-0.910.
Step 2. a,=*7, = {2, 4}, n(7,, a , ) < 0 .
Step 3. a-'=0.910, 7* = {2. 4}.
Step 4. 11(7,. a') = 0=> a' = 0.776.
Step 5. ' E p . 0.910(= ;t = 2, a^ 0.776.
Step 2. 02=* 7^ = {1. 4}, 11(72. "2) > 0-
Step 3. a - =0.776, 7 - = {1,4}.
Step 4. 11(72, ') = 0=* a ' = 0.817.
Step 5. a' ElO.776, 0.910(= A; = 3, a, == 0.817.
Step 2. 03 => 73 - {2, 4}, n(73, a j X 0.
Step3. +=0.817, 7 + = {2, 4}.
Step 4. Il(7j, a') = 0 =* a' = 0.776.
Steps. '^10.776, 0.817[.
5/e/^6. 0(7", a*) = ^(7-^, a*)=>a* = 0.800, 7 - = {1,4} and 7^ = {2, 4} are
optimal for a*, terminate with a duality gap solution.
The solution obtained at a* = 0.800 reveals a duality gap for the pair of solutions
7 - - {1, 4} and 7+ {2,4}, with profits n ( 7 - , a*) = 2.78 and n(7-', a*)= -3.89.
The upper bound 0(7 ~, a*)/a* on net social benefits with zero profits is 122.92. The
best zero-profit solution obtained in Step 4 of the procedure is for 7= {1,4} and
a = 0.817, with net social benefits of 122.88. This solution is very close to the upper
bound. If we branch on either / , or y2, the solution {1,4} at a = 0.817 is verified
immediately as the optimal quasi-public solution.
The consequences of solutions to this example for the three types of objective
specificationprivate, quasi-public, and publicare summarized in Table 3. Each
solution yields a different facility combination, and none of the facilities established
in the public and quasi-public cases occurs in the solution with the private objective.
Compared with the public objective, the quasi-public solution eliminates a sizable loss
with a decrease of only 5.5% in total net social benefits. Elimination of the loss is
accomplished by a considerable shift in benefits from consumers to the producing
enterprise through price increases, and by deleting the facility at location 2 to reduce
fixed costs. In contrast, the profit-maximizing solution entails a large reduction in
total net social benefits.
The pricing results given in Table 3 provide further insight into the implications of
the three solutions. The two demand locations with more inelastic demand (7 = 2, 4)
bear major price increases in the transition from the public to the quasi-public
solution. Location 2, whose minimum-cost supplying facility is deleted, suffers almost
a four-fold increase in price. But prices for each location in the profit-maximization
case are still considerably higher. The prices given in Table 3 are delivered prices. If
we compute ex-facility prices by subtracting the variable destination costs t,j from
these delivered prices, price ^discrimination is evident in both the private and quasi-
public solutions since the ex-facility price varies with the demand location supplied.
 FACILITY LOCATION WITH PRICE-SENSITIVE DEMANDS 385
TABLE 1
Data for Quadraiic Revenue Example

1 2 3 4
1 2 6 8 14 15
2 6 2 4 10 25
3 8 6 2 6 20
4 12 10 4 2 30
8 18 10 22
1 2 1 2

1 2 3 4
1 36 72 4 32
2 4 128 36 72
3 0 "2 64 128
4 0 32 36 200

TABLE 2
Solutions for Quadratic Reoenue Example
Optimal facility Range for optimality
set,/ with Lagrangian objective
{3) 0<a < 0.400
0400 < 0 < 0.800
{2! 4} 0.80O < a < 0.933
{1.2,4 } 0.933 < a < 1.000

TABLE 3
Comparison of Solutions to Location Example
Private Quasi-public Public
f"{3}
i /-{1,4} / { 1 . 2 , 4 }
Benefit category a-0 a - 0.817
Consumers' surplus 33 122.88 200
Net profits 46 0 -70
Net social benefits 79 122.88 130
Price at location:
y-1 8.00 2.93 2.00
2 12.00 7.86 2.00
3 6.00 4.93 4.00
4 14.00 5.10 2.00

6. CoiKlusions
As we have shown, the reformulation of the facility location model with price-
sensitive demands into an equivalent fixed-demand model simplifies the calculation of
coordinated pricing and location decisions. Unfortunately, many of the modifications
to the model that would increase its applicability seem to rule out this reformulation.
One extension that can be accommodated is a piecewise-linear, concave facility cost.
As Hansen and Thisse [9] have shown for the profit-maximization case, Efroymson
386 DONALD ERLENKOTTER

and Ray's trick (4] of defining a new candidate facility for each linear segment may be
applied here also. However, other modifications such as placing limits on the amount
of capacity established at each location do not seem easily incorporated.
A key assumption in the model is that benefits accruing to consumer groups at
different locations can be added to obtain total benefits. Equity issues arising from
the distributional impact of various solutions are not considered explicitly. Benefits at
different locations could be weighted differently or upper bounds could be specified
on prices by location without difficulty. But a general nonseparable benefit function
would be intractable, as would a situation of interdependence between demands at
various locations.
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