Nested logit and grouped substitution
In choicer: Discrete Choice Models for Economic Applications

knitr::opts_chunk$set(collapse = TRUE, comment = "#>")
options(digits = 4)

Nested logit groups alternatives into nests of close substitutes. Within a nest, alternatives share an unobserved component, so substitution is stronger inside a nest than across nests. Each non-singleton nest has a positive dissimilarity parameter λ; singleton nests have λ fixed at 1 because no within-nest variation can identify it. The usual random-utility interpretation of nested logit focuses on 0 < λ <= 1: λ = 1 gives the MNL limit, and smaller λ means tighter substitution inside the nest. choicer imposes λ > 0 rather than an upper bound. Estimates above one are mathematically computable but imply negative within-nest correlation and should be treated as evidence against the proposed nesting structure, not as the usual "close substitutes" interpretation.

Think of nested logit as the parsimonious middle ground between the multinomial and mixed logits. It introduces genuine within-nest correlation in unobserved utility at the cost of just one extra parameter per nest, and it stays globally well-behaved and cheap to estimate (a closed-form GEV likelihood, no simulation). The price you pay is a strong prior: you must specify the nesting tree in advance, and the model only permits correlation within the nests you draw. When the right grouping is obvious from the application (travel modes, product categories), that is a defensible restriction; when it is not, the result can be sensitive to how you nest. A good nested-logit application therefore treats the tree as an economic assumption, not as a tuning parameter chosen after looking at fit statistics. See Choosing among choice models for how this tradeoff compares with the alternatives.

library(choicer)
set_num_threads(2)

Simulate a nested process

simulate_nl_data() builds two nests of inside goods plus an outside option, with known dissimilarity parameters.

sim <- simulate_nl_data(N = 4000, seed = 1)
sim

Fit

Supply the nest membership column; choicer estimates the coefficients, the alternative-specific constants and the nest dissimilarity parameters jointly, using an analytical gradient and Hessian.

fit <- run_nestlogit(
  data                   = sim$data,
  id_col                 = "id",
  alt_col                = "j",
  choice_col             = "choice",
  covariate_cols         = c("X", "W"),
  nest_col               = "nest",
  use_asc                = TRUE,
  include_outside_option = TRUE,
  outside_opt_label      = 0L
)
summary(fit)

Parameter recovery

The lambda rows are the nest dissimilarity parameters — the part that is unique to nested logit.

recovery_table(fit, sim$true_params)

What identifies the dissimilarity parameters?

It is worth being explicit about where each parameter block gets its information. The coefficients on X and W are identified, as in any logit, by how utilities respond to covariate variation. The dissimilarity parameters are identified by reallocation: when an observed utility shifter moves, does the displaced demand stay inside the nest or spill across nests? Alternative-specific covariates that vary within nests are therefore the variation that disciplines λ. If the covariates move whole nests together — or the specification is mostly alternative-specific constants — λ is pinned down mainly by functional form, and a wide confidence interval on a lambda row is the model saying the data cannot see inside that nest.

The estimate's position in (0, 1] is itself informative. A λ near 1 says the data see no extra within-nest correlation: the MNL was adequate, and the nest costs a parameter without buying substitution structure. A λ near 0 says the nest's alternatives are nearly perfect substitutes at the nest margin, which carries a sharp welfare implication: the nested logsum discounts within-nest variety by λ, so adding an alternative to a tight nest adds almost no expected consumer surplus, while adding one to a loose nest adds a lot. Welfare counterfactuals computed with consumer_surplus() inherit exactly this structure — one more reason to treat the tree as an economic assumption rather than a fit device.

Nest-consistent elasticities

This is the payoff of nesting: cross-elasticities are larger for alternatives in the same nest than for alternatives in different nests. choicer's elasticities() respects the nest structure automatically.

elasticities(fit, elast_var = "W")
diversion_ratios(fit)

Those substitution patterns are credible only to the extent that the nesting tree is credible. If plausible alternative trees imply materially different diversion or welfare conclusions, that sensitivity is part of the empirical result rather than a nuisance to hide.

Share inversion with BLP

blp() runs the Berry-Levinsohn-Pakes contraction to recover the mean utilities that reproduce a set of target shares — useful for calibration and demand estimation from aggregate data. For strongly-nested models a damping factor below 1 stabilizes the iteration.

target_shares <- predict(fit, type = "shares")
head(blp(fit, target_shares, damping = 0.5))

As always, predict(), wtp() and consumer_surplus() are available on the fitted object with the same syntax used throughout choicer.

Empirical checklist

A reportable nested-logit specification should show the proposed tree and its economic rationale; report every estimated lambda and uncertainty interval; identify singleton nests, whose lambda is fixed at 1 by choicer because there is no within-nest variation to learn from; and flag estimates outside the conventional random-utility range 0 < lambda <= 1. Refit plausible alternative trees and compare fit, diversion, elasticities, WTP, and welfare—not just the coefficient table.

When using blp(), verify that shares reconstructed from the returned mean utilities match the target within the stated tolerance, and report sensitivity to damping. (The current return value is the utility vector, not a convergence diagnostics object.) Damping is a numerical aid, not evidence for the tree or the economic validity of lambda. NL does not search over trees or estimate cross-nested substitution, so uncertainty about the grouping remains specification uncertainty outside the reported standard errors.

The full derivations — the GEV likelihood, analytical gradient and Hessian, nest-consistent elasticities and diversion, and how choicer's utility-maximization-consistent parameterization relates to the non-normalized nested logit found in some other software — are in the math companion.

References

Heiss, F. (2002). Structural choice analysis with nested logit models. The Stata Journal, 2(3), 227-252.

McFadden, D. (1978). Modelling the choice of residential location. In A. Karlqvist et al. (Eds.), Spatial Interaction Theory and Planning Models. North-Holland.

Train, K. E. (2009). Discrete Choice Methods with Simulation (2nd ed.). Cambridge University Press, Chapter 4.