Basic Discrete choice models

Discrete choice model

Discrete choice models can be used to analyze a decision maker’s
choice of one alternative from a finite set of alternatives.

Four elements:
Ø Decision maker

Ø Alternatives
universal choice set, feasible choice set, consideration choice set

Ø Attributes of alternatives
generic or alternative-specific

Ø Decision rule
utility maximization; random choice; variety seeking; etc.
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 Utility-Based Choice Theory
Utility: An indicator of value to a decision maker

The utility maximization rule: a decision maker will select the

alternative that maximizes his/her utility.

If U i ³ U j "j Þ i ! j " jÎC

U : utility function
i, j : alternative
C : choice set

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 Deterministic Choice Concepts
Deterministic choice concepts imply no uncertainty in decision
process; that is, a decision maker is certain to choose the
alternative with highest utility.

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 Probabilistic Choice Theory
The utility function is decomposed into two components:

U in = Vin + e in

Where
U in : the utility of the alternative i to the decision maker n
Vin : the deterministic term of the utility
e in : the error term unknown to the analyst

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Multinomial Logit (MNL) model
Mode choice
U car = Vcar + e car (1) are Gumbel distributed

(2) are identically and independently

U bus = Vbus + e bus distributed across alternatives

(3) are identically and independently

distributed across decision makers
U rail = Vrail + e rail

exp(Vcar )
Pr(car ) =
exp(Vcar ) + exp(Vbus ) + exp(Vrail )
exp(Vbus )
Pr(bus ) =
exp(Vcar ) + exp(Vbus ) + exp(Vrail )

exp(Vrail )
Pr(rail ) =
exp(Vcar ) + exp(Vbus ) + exp(Vrail ) 6
 Maximum Likelihood Estimation
Two steps:
1) Developing a joint probability density function of the observed
sample, called the likelihood function;

Likelihood function:
d jn
L = Õ Õ ( Pjn )
nÎ N jÎJ

Where d jn =1 if j is chosen by individual n and 0 otherwise

Pjn is the probability that individual n chooses alternative j

2) Estimating parameter values which maximize the likelihood

function.
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 Independence of Irrelevant
Alternatives (IIA) property
The ratios of each pair of probabilities are:
Pr (car) exp(Vcar )
= = exp(Vcar - Vbus )
Pr(bus ) exp(Vbus )

Pr (car) exp(Vcar )
= = exp(Vcar - Vrail )
Pr(rail ) exp(Vrail )

Pr (bus) exp(Vbus )
= = exp(Vbus - Vrail )
Pr(rail ) exp(Vrail )

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 Limitation
Example:

Car Bus Rail

Choice probability before 60% 20% 20%

improvements to rail
Choice probability after
improvements to rail 54% 18% 28%

Proportional Change in -10% -10% +40%

Choice Probabilities

U car = Vcar + e car

U bus = Vbus + e bus
U rail = Vrail + e rail
MNL model does not take
account of the correlation
correlation between error terms of
different alternatives
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Formulation of Nested Logit Model
The derivation of the nested logit model is based on the
assumption that some of the alternatives share common
components in their random error terms.

Alternative Utility function for MNL Utility function for NL

U car = Vcar + e car U car = Vcar + e car

U bus = Vbus + e bus U bus = VPT + Vbus + e PT + e bus

U rail = Vrail + e rail U rail = VPT + Vrail + e PT + e rail

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Formulation of Nested Logit Model
The total error for each alternative is assumed to be distributed
Gumbel with scale parameter equal to one. The variance of
these distributions is:
p2
Var (e car ) = Var (e PT + e bus ) = Var (e PT + e rail ) =
6

The distinct error components, εbus and εrail , also are assumed to
be distributed Gumbel, but with scale parameter μpt. In practice
we estimate the inverse of the scale parameter θpt=1/ μpt.
p2 p 2θ PT 2
Var (e bus ) = Var (e rail ) = 2
=
6 μ PT 6

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 Formulation of Nested Logit Model
The choice probabilities for the lower
level nested alternatives (bus or rail),
conditional on choice of public
transportation mode are given by:
Car PT exp(Vbus /θ PT )
Pr(bus / PT ) =
exp(Vbus /θ PT ) + exp(Vrail /θ PT )

exp(Vrail /θ PT )
Pr(rail / PT ) =
Bus Rail exp(Vbus /θ PT ) + exp(Vrail /θ PT )

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Formulation of Nested Logit Model
The marginal choice probabilities for the car and public
transportation alternatives are:
exp(Vcar )
Pr(car ) =
exp(Vcar ) + exp(VPT + θ PT Γ PT )

exp(VPT + θ PT Γ PT )
Pr( PT ) =
exp(Vcar ) + exp(VPT + θ PT Γ PT )
where,
Γ PT = log(exp(Vbus /θ PT ) + exp(Vrail /θ PT ))

The probability of choosing bus and rail can be represented as:

Pr(bus ) = Pr(bus / PT ) ´ Pr( PT )
Pr(rail ) = Pr(rail / PT ) ´ Pr( PT )

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Formulation of Nested Logit Model
The log-likelihood function is:
LogL = ån ln(Pr(car )d car ´ Pr( PT )d PT ´ Pr(bus / PT )d bus ´ Pr(rail / PT )d rail )

where, δcar =1 if individual n choose car, 0 otherwise;

δPT =1 if individual n choose bus or rail, 0 otherwise;
δbus =1 if individual n choose bus, 0 otherwise;
δrail =1 if individual n choose rail, 0 otherwise.

Nested model can be estimated using standard maximum

likelihood estimation method.

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 Logsum Parameter

θ>1 Not consistent with the theoretical derivation

θ =1 Collapses to the MNL model

0< θ < 1 Implies non-zero correlation among pairs of alternatives in the nest

θ =0 Implies perfect correlation between pairs of alternatives in the nest

θ<0 Not consistent with the theoretical derivation

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 Nesting Structure
Example: 4 alternatives

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Statistical Testing of Nesting Structure
NL vs. MNL
We can reject the null hypothesis that the MNL model is the correct model if
the calculated value is greater than the critical value for the distribution as:

- 2 ´ [! MNL - ! NL ] ³ c n2

where n is the number of restrictions (nests) between the MNL and NL models.

Different nesting structure

1) Test of logsum parameters
2) chi-square test

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 A Example of NL model
Example: mode choice

Alternative: car, bus, railway

Vcar= βage_c*Age+ βgender_c*Gender + βtime*Tcar+ βfare*Fcar

Vbus= βage_b*Age+ βgender_b*Gender + βtime*Tbus+ βfare*Fbus

Vrail= βtime*Trail+ βfare*Frail

VPT= constant

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Explanatory variable MNL NL
Parameter t-value Parameter t-value
Constant -5.39 -3.22** -4.62 -3.23**
Age_C -0.14 -2.95** -0.14 -3.18**
Age_B -0.02 -0.29 -0.03 -0.57
Gender_C 0.65 1.01 0.74 1.17
Gender_B -0.86 -1.41 -0.53 -1.36
Time -0.12 -3.33** -0.08 -2.42*
Fare -0.01 -4.77** -0.01 -3.47**
Logsum 0.54 2.71**
(2.30 *)
Sample size 100
Initial log-likelihood -109.86
Converged log-likelihood -64.68 -63.20
McFadden's Rho-squared 0.41 0.42
Adjusted McFadden's Rho-squared 0.34 0.35
χ2 statistic to test whether NL outperforms MNL or not 2.96 > 2.71 (critical value: df=1, 90% level)
* significant at the 95% level, ** significant at the 99% level
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