DSC4213 Analytical Tools for

Consulting

Session 4 Modeling Demand and Choice:

The Multinomial Logit model

Prof. WANG Tong

Dept. of Decision Sciences
NUS Business School
 Estimation Demand -- Data Sources

• Sales transaction data

– POS
– Loyalty program
– Web clicks, sensor networks

• Third-party data
– Industry research (A. C. Nielsen, etc.)
– Macro-economic data

• Survey/experimental data
– Questionnaires
– Live experiments

• Expert Judgment

Aug 2016 DSC4213 Session 4 - Prof. WANG Tong 2

 NYHC

• Survey data on WTP

– Multiple products: 6 time slots
– Multiple segments: student, others

Client MAXIMUM WTP for each time period Max.WTP

ID 6am-9am 9am-noon Noon-2pm 2pm-5pm 5pm-9pm 9pm-close Day
1 75 25 50 25 75 50 75
2 25 25 25 25 75 75 75
3 25 25 25 25 50 50 50
4 25 25 25 25 50 75 75
5 75 75 75 75 75 75 75
6 25 25 25 25 75 75 75
7 25 25 25 25 25 25 25
8 50 50 50 50 50 50 50
9 100 100 100 100 100 100 100
10 100 100 100 100 100 100 100
11 25 25 25 25 50 25 50
12 50 75 150 75 150 75 150
13 25 25 25 25 25 25 25
14 50 75 100 100 125 100 125
Aug 2016 15 100 125 125 4 - Prof.
DSC4213 Session 125 125
WANG Tong 100 125 3
 Willingness-To-Pay (WTP)

• WTP (a.k.a. reservation price, valuation) is the maximum amount a

potential customer is willing to pay for a product
– Customer will buy if WTP ≥ p (surplus WTP -p ≥ 0)
– Customer will not buy if WTP < p (surplus WTP -p < 0)

• If the distribution of WTP in a given population of size N is F(w) =

Pr(WTP<w)
Pr(one buys at price p) = Pr(WTP ≥ p) = 1-F(p)

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 The Choice Process

• Customer assigns utilities (WTP) for each alternative i

ui = utility for alternative i

• Price of alternative i

pi = price for alternative i

• Deterministic choice: customer picks the alternative with the highest Net
Utility (surplus)

max {0, u1-p1, u2-p2, … , un-pn}

• Customer does not buy if all net utilities are negative

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 NYHC Q1: single price

• Histogram

Max WTP
40

35

30

25

20

15

10

0
25 50 75 100 125 150

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 NYHC Q1: single price

• Demand and revenue

• P* = $75

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 Estimation -- Parametric vs. nonparametric

• Nonparametric estimation
– Use raw data to directly
• Empirical histogram of demand volume
• Empirical histogram of reservation prices
– Pros: no assumptions, directly from observed data
– Cons: cannot extrapolate beyond data, hard to optimize, over-fitting

• Parametric estimation
– Assume a demand model with modest number of parameters, and estimate
parameters from data
• Linear: D(p) = a – bp
• Normal : D ~ N(µ, σ2)
– Pros: concise description, mathematically tractable, can extrapolate beyond data
– Cons: assumptions on the form of response may not be valid

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 Parametric Demand Models

• Demand Functions D
– Non-negative
– Downward sloping
– Continuous (hopefully)
– Differentiable (ideally)
• Exceptions not considered
P
– Luxury goods
– Giffen goods
– Goods that its price affects the perceived quality
• Measures of price effect
– Price sensitivity: increase p by $1, demand decreases by ?
• Unit dependent
– Price elasticity: increase p by 1%, demand decreases by ?%

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 Common Demand Functions (Single-Product)
Linear Exponential Iso-elastic
Demand D(p) = a–bp D(p) = exp(a-bp) D(p) = a p-e, e > 1

WTP
Distribution
Uniform Exponential

D = a – bp D = exp(a-bp) D = a p-e

|ϵ|
|ϵ|
|ϵ|

Estimation D = a – bp Log(D) = a – bp Log(D) = Log(a) – e log(p)

Constant sensitivity Constant elasticity

Optimizatio p* = c*e/(e-1) (c is unit

P* = a/2b P* = 1/b
n cost)

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 NYHC Q1: single price

• Linear demand: D(p) = 11362 - 84.755p

• P* = a/2b = $67

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 NYHC Q1: single price

• Exponential demand: D(p) = exp(10.4 – 0.0348p)

• P* = 1/b = $29

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 NYHC Q1: single price

• Iso-elastic demand: D(p) = exp(13.584) * p^(-1.434)

• P* = ??

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 NYHC Q2

• Price 5pm-9pm and fix other slots at $50

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 NYHC Q2

• Choice by Net Utility maximization

• P* = $60

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 NYHC Q3

• Price both 5pm-9pm and other slots

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 Modeling Choice

• What if there are multiple alternatives to price?

• Examples:
– Multiple versions of a product
– Competing products

• Models:
– Multi-product demand functions
– Discrete choice models

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 Multi-product Demand Functions

• Two-product linear demand

d1(p1, p2) = a1 – b11 p1 + b12 p2

d2(p1, p2) = a2 – b22 p2 + b21 p1

– Parameter estimation can be done by regressing each demand against both prices

• Multi-product iso-elastic demand functions are also available

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 Multinomial Logit (MNL) Choice Model

• Incorporate a random component in the net utility

utility for i = ui – pi + ξi

• Random component ξ’s are assumed to be independent and have Gumbel

distribution with mean zero and variance σ2 = s 2 π 2 / 6

• Given n alternatives, then

𝑉. 67 897
Pr(chooses i) = , 𝑉. = 𝑒 :
1 + 𝑉1 + ⋯ + 𝑉3

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 Multinomial Logit (MNL) Choice Model

• Demo of the MNL model: 5pm-9pm vs others

Choices 5pm-9pm Others

WTP $100 $75

Price P $50

Net Utility 100-P 25

• Under deterministic choice, as long as P ≤ 75,

Pr(choose 5pm-9pm) = 1

• Under MNL, the probability looks like

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 Multinomial Logit (MNL) Choice Model

• MNL choice probability for different levels of uncertainty s

1

0.9

0.8

0.7

0.6 deterministic
s=1
0.5
s=10

0.4 s=100
s=10000
0.3

0.2

0.1

0
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
100
104
108
112
116
120
124
128
132
136
140
144
148
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 NYHC B: Estimate MNL from WTP data

• Determine ui based on data

ui = average(WTPi)

• s is derived from average of var(WTPi)

• Prediction
– Calculate Vi = exp( (ui – pi) / s)

– Purchase probability

Pr( buy i) = Vi / (1 + V1 + V2 + … + VN)

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 Challenges in using MNL

• Model
– Independence of Irrelevant Alternatives (IIA)

• Optimization
– Not trivial

• Data & Estimation

– Often WTP is not available
– But we have actual choices from sales data
– Maximum Likelihood Estimation (MLE)

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 Model

• Independence of Irrelevant Alternatives (IIA)

– Probi / Probj depends only on their own net utilities NUi and NUj, not on other
alternatives (proportional substitution)
– Was the original motivation of the logit model
– Not always appealing, e.g. (red-bus-blue-bus problem)
• Choice between Car and Red Bus, same NU => 50%-50% choice
• If add Blue Bus as the third option, again same NU
– Intuition: 1/2, 1/4, 1/4
– MNL prediction of choice probabilies: 1/3, 1/3, 1/3

• Extentions
– Probit model: multivariate Normal ξi
– Generalized extreme value (GEV) model: allow correlation in ξi
– Nested logit: allow hierarchical choices
– Mixed logit: individual variations

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 Optimization

• Given an MNL demand model, we choose prices Pi to maximize total

revenue
Revenue = 𝑃1 @ 𝐷1 (𝑃) + 𝑃B @ 𝐷B (𝑃) + ⋯ + 𝑃C @ 𝐷C (𝑃)
𝑃1 @ 𝑉1 𝑃1 + 𝑃B @ 𝑉B 𝑃B + ⋯ + 𝑃C @ 𝑉C 𝑃C
= 𝑁
1 + 𝑉1 𝑃1 + 𝑉B 𝑃B + ⋯ + 𝑉C 𝑃C
• The revenue function is in general not concave or unimodal
– Generic solvers will not work (reliably)
– Ad-hoc algorithms exist (Hanson and Martin, 1996, Mgmt. Sci.)

• Special cases that are solvable:

– When there is only one option to price (Fjord case)
– When there are multiple options, but all prices are the same

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 Estimation based on choice data

• NYHC Data
– Price =$50 for all slots
– Observed choices
Noon-
Client 6am-9am 9am-noon 2pm 2pm-5pm 5pm-9pm 9pm-close No-purchase
1 1 0 0 0 0 0 0
2 0 0 0 0 1 0 0
3 1 0 0 0 0 0 0
4 0 0 0 0 1 0 0
5 0 0 0 0 1 0 0
6 0 0 1 0 0 0 0
7 0 0 0 0 0 1 0
8 0 0 0 0 0 1 0
9 0 0 0 0 1 0 0
10 0 0 0 0 0 1 0
11 0 0 0 0 1 0 0
12 0 0 0 0 0 0 1
13 0 0 0 0 1 0 0
14 0 0 0 0 0 0 1
15 0 0 0 1 0 0 0

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 Maximum Likelihood Estimation (MLE)

• A standard statistical method for parameter estimation

• Brief idea: find the most likely values of the parameters that lead to the
observed data

• Quick example
– Two possible models: f(x | u1) and f(x | u2)
– Data: x1, x2, …, xn
– Likelihood of the two models:
• f(data|u1) = f(x1|u1) f(x2|u1) … f(xn|u1) = L(u1|data)
• f(data|u2) = f(x1|u2) f(x2|u2) … f(xn|u2) = L(u2|data)
– Choose the one with max likelihood

• Often max log(Likelihood) instead

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 Estimation based on choice data

• Recall in MNL, the probability of choice is

𝑉. 67 897
Pr(chooses i |𝑢, 𝑠) = , 𝑉. = 𝑒 :
1 + 𝑉1 + ⋯ + 𝑉H
Noon-
Client 6am-9am 9am-noon 2pm 2pm-5pm 5pm-9pm 9pm-close No-purchase
1 1 0 0 0 0 0 0
2 0 0 0 0 1 0 0
… … … … … … … …
100 0 0 0 0 0 0 1

• Likelihood of Client 1 choosing 1 and Client 2 choosing 5 is

Pr(chooses 1 |𝑢, 𝑠) @ Pr(chooses 5 |𝑢, 𝑠)

• Likelihood of seeing the whole data set is

Pr(chooses 1 |𝑢, 𝑠) @ Pr(chooses 5 |𝑢, 𝑠) @ ⋯ @ Pr(chooses 0 |𝑢, 𝑠) = L(𝑢, 𝑠|data)

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 Estimation based on choice data

• Solving max L(𝑢, 𝑠|data) or max log L 𝑢, 𝑠 data yields the maximum likelihood
6,: 6,:
estimate

s= 9.888807
9am- Noon- 5pm- No
6am-9am noon 2pm 2pm-5pm 9pm 9pm-close Purch.
Price $ 50.00 $ 50.00 $ 50.00 $ 50.00 $ 50.00 $ 50.00
Total Log
uj $ 55.05 $ 34.08 $ 44.95 $ 39.14 $ 55.81 $ 50.64 Likelihood
Net util. $ 5.05 $ (15.92) $ (5.05) $ (10.86) $ 5.81 $ 0.64 0 -75.98299317
vj 1.666646 0.199999 0.599996 0.333329 1.79998 1.066657 1
pj 0.249999 0.03 0.09 0.05 0.269999 0.16 0.150001

9am- Noon- 5pm- No

Client 6am-9am noon 2pm 2pm-5pm 9pm 9pm-close Purch. Likelihood
1 0 0 0 0 0 1 0 0.15999999
2 1 0 0 0 0 0 0 0.249999182
3 0 0 0 0 1 0 0 0.269999435
4 0 0 0 0 1 0 0 0.269999435
5 1 0 0 0 0 0 0 0.249999182
6 0 0 0 0 0 1 0 0.15999999
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 Estimation based on choice data
Noon-
Client 6am-9am 9am-noon 2pm 2pm-5pm 5pm-9pm 9pm-close No-purchase
1 1 0 0 0 0 0 0
2 0 0 0 0 1 0 0
… … … … … … … …
100 0 0 0 0 0 0 1

• Aggregate demand
Demand 25 3 9 5 27 16 15

• Likelihood is
H

L(𝑢, 𝑠|data) = S Pr(chooses i |𝑢, 𝑠)Demand7

.UV
• Log-Likelihood is
H
LL(𝑢, 𝑠|data) = W Demand. @ Log(Pr(chooses i |𝑢, 𝑠))
.UV

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 MNL with more explanatory variables

• Utility can be a function of various explanatory variables

𝑢. = 𝑎1 𝑥1. + 𝑎B 𝑥B. + ⋯ + 𝑎Z 𝑥Z.
– 𝑥\. is attribute 𝑘 for alternative 𝑖
– 𝑎\ is unknown coefficient for attribute k

• Can be similarly estimated by MLE => Logistic Regression

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 Summary

• Single-product demand models

– WTP distribution ó Demand curve
– Estimation: parametric/nonparametric, transaction/survey
– Linear/Exponential/Iso-elastic demand

• Discrete Choice Models

– Deterministic choice: maximize net utility ui – pi
– Random utility model: ui – pi + ξi
• Multinomial logit: ξi independent, zero mean, σ2 = s 2 π 2 / 6

• Challenges and solutions in applying MNL

– Model: IIA
– Optimization
– Estimation: MLE for choice data

Aug 2016 DSC4213 Session 4 - Prof. WANG Tong 32