Brownian inventory models with convex holding cost, Part 2: Discount-optimal controls

Abstract

We consider an inventory system in which inventory level fluctuates as a Brownian motion in the absence of control. The inventory continuously accumulates cost at a rate that is a general convex function of the inventory level, which can be negative when there is a backlog. At any time, the inventory level can be adjusted by a positive or negative amount, which incurs a fixed positive cost and a proportional cost. The challenge is to find an adjustment policy that balances the inventory cost and adjustment cost to minimize the expected total discounted cost. We provide a tutorial on using a three-step lower-bound approach to solving the optimal control problem under a discounted cost criterion. In addition, we prove that a four-parameter control band policy is optimal among all feasible policies. A key step is the constructive proof of the existence of a unique solution to the free boundary problem. The proof leads naturally to an algorithm to compute the four parameters of the optimal control band policy.