Graphical Models for Economic Profit Maximization

Decision trees and influence diagrams are utilized to analyze and solve profit maximization problems from economics. As a complement to traditional analytical methods for solving these problems, use of these graphical representations allows students to learn about the effects of uncertainty on pricing and capacity choices. Decision trees are first used to model a firm's production capacity and pricing decisions when these choices are made simultaneously under certain and uncertain demand. The decision tree approach is next extended to a situation where the firm makes its capacity and price selections under different information constraints. The use of these problems as part of a case assignment in a writing-intensive managerial economics course is discussed. Influence diagrams are also presented as an alternative modeling technique that can easily accommodate more potential values for decision variables when solving these problems. By studying the effects of uncertainty on profit maximization problems, students can also learn to appreciate that dealing with uncertainty is important in many business decisions.