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Discrete Choice Models

Discrete choice models are used to forecast demand when the dependent variable is discrete, such as a customer choosing between products. These models relate discrete choice variables to factors like price through nonlinear functions that output values between 0 and 1, such as the logit function used in multinomial logit models. Multinomial logit models allow estimating the probability of each choice based on factor values and have relatively easy parameter estimation.

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Vikash Movva
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42 views

Discrete Choice Models

Discrete choice models are used to forecast demand when the dependent variable is discrete, such as a customer choosing between products. These models relate discrete choice variables to factors like price through nonlinear functions that output values between 0 and 1, such as the logit function used in multinomial logit models. Multinomial logit models allow estimating the probability of each choice based on factor values and have relatively easy parameter estimation.

Uploaded by

Vikash Movva
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Forecasting Demand – Discrete Choice Models

Anton J. Kleywegt, Ph.D.


School of Industrial and Systems Engineering
Review of Previous Lesson

• We use causal models when we have data not


just about the dependent variable of interest,
but also about various factors that we think
are related with the dependent variable
• Linear regression models are simple, easy to
calibrate models that include these factors
• Factors are encoded into explanatory variables
that capture the effects of the factors on the
dependent variable using chosen basis
functions
• Categorical factors, encoded using binary
variables (indicator variables or dummy
variables) are especially useful in models
• Model parameters are estimated from data by
minimizing the sum of squared errors, or sum
of absolute errors, or similar error measures
Learning Outcomes
• Become familiar with the reasons for using discrete
choice models
• Develop skill in formulating and interpreting discrete
choice models
Forecasting Methods
• Classification of forecasting methods according to Armstrong, J.S. Long-range
Forecasting, Second Edition, 1985
Discrete Choice Models
• Suppose that the dependent variable Y of interest is discrete
• Examples
• Y = 0 if the democratic candidate wins the presidential election, and Y = 1 if the
republican candidate wins the presidential election
• Y = a if a customer chooses to buy product a, Y = b if the customer chooses to buy
product b, and Y = 0 if the customer chooses not to buy either product
• Y = c if a customer cancels an order and replaces it with a new order (changes the
order), Y = d if the customer cancels an order and asks for a refund, Y = e if the
customer cancels an order, does not replace it with a new order, and does not ask
for a refund, and Y = 0 if the customer does not cancel the order
Discrete Choice Models
• Suppose you have data on the dependent variable Y of interest, as well as different
factors Z1, Z2, …, Zm that you think affect Y
• For example, Y = a if a customer chooses to buy product a, Y = b if the customer
chooses to buy product b, and Y = 0 if the customer chooses not to buy either
product, Z1 denotes the price of product a during the week, and Z2 denotes the
price of product b during the same week
• You want to propose (based on intuition, experience, and/or trial-and-error) a relation
between the dependent variable Y of interest and chosen functions, called basis
functions or feature functions, of the factors Z1, Z2, …, Zm
• Call the basis functions
Discrete Choice Models
• Suppose one considers a linear model, as follows:
Discrete Choice Models
• Proposed linear model:

• Problem with linear model: The dependent variables take values 0 and 1 only, whereas
the linear expressions can take on any real value
Discrete Choice Models
• Partial fix for problem with linear model:

• Now the dependent variables are allowed to take on any values between 0 and 1
Discrete Choice Models
• Partially fixed linear model:

• Problem with the partially fixed linear model: The dependent variables take values
between 0 and 1 only, whereas the linear expressions can take values less than 0 or
more than 1
Discrete Choice Models
• Further fix:

• Note that this is not a linear model anymore – it is a nonlinear model, and it has lost the
nice properties of linear models
Discrete Choice Models
• There are many other nonlinear models to consider
• We can use any function G that takes values between 0 and 1 only:
Discrete Choice Models
• Popular, and simple idea: Take any function H that takes positive values only:
Discrete Choice Models
• Same idea, more generally stated:
• Set N of decision makers (potential customers)
• Each customer n has a set Sn of alternatives to choose from, including the null
alternative (for example, not to buy anything)
• There are factor values Z1,…,Zm that you think affect the dependent variables
(choice probabilities), for example Z1 denotes the price of product a during the
week, and Z2 denotes the price of product b during the same week
• For each customer n, and each alternative i in Sn, a vector of basis functions of the
chosen factors are formulated:
Discrete Choice Models
• Same idea, more generally stated (continued):
• Take any function H that takes positive values only
Discrete Choice Models
• One of the most popular choices for H:
Discrete Choice Models

• Example
• Each customer chooses product a or product b or neither (alternative 0)
• Thus, Sn = {a,b,0} for each customer n
• We want to forecast
Discrete Choice Models

• Example (continued)
• Chosen factors and basis functions:
Discrete Choice Models
• Example (continued)
• The resulting Multinomial Logit (MNL) model is
Discrete Choice Models
• Example (continued)
• Binary logit model: Binary logit model

0.9

0.8

Probability of purchase
0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
0 10 20 30 40 50 60 70 80 90 100
Price
Summary
• Modern demand models describe how customers
choose among available alternatives
• Linear regression models cannot model choices
among discrete alternatives
• There are various nonlinear regression models that we
can use to model customer choices
• One of the most popular and simple discrete choice
models is the multinomial logit model
• Parameter estimation for multinomial logit models is
relatively easy, and there are many software packages
that can calibrate parameters for multinomial logit
models, given good data

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