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Air transport liberalization and its impacts on airline competition and air passenger traffic.

Abstract

This study examines the impacts of air transport liberalization policies on economic growth, traffic volume, and traffic flow patterns, and investigates the mechanisms leading to those changes. Our investigation concludes that (1) liberalization has led to substantial economic and traffic growth. Such positive effects are mainly due to increased competition and efficiency gains in the airline industry, as well as positive externalities to the overall economy; (2) liberalization allows airlines to optimize their networks within and across continental markets. As a result, traffic flow patterns will change accordingly. Strategic alliance is a second-best solution and will have a reduced role when foreign ownership restrictions are relaxed; (3) there is a two-way relationship between the expansion of low-cost carriers (LCCs) and liberalization. The rapid growth of LCCs leads to increased competition and stimulated traffic, calling for the removal of restrictions on capacity, frequency, pricing and entry. In addition, development of LCCs in domestic markets can promote liberalization policy for international aviation by increasing the competitiveness of the national aviation industry. On the other hand, the existing regulations hindered the growth of LCCs. Further liberalization is needed for the full realization of associated benefits.

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International air transport operates within the framework of the 1944 Chicago Convention on international air transportation, under which airlines' commercial rights on international routes are governed by a complex web of more than 10,000 bilateral air services agreements (ASAs) between each country-pair. These ASAs regulate a wide range of conditions related to the provision of international air services. The World Trade Organization (WTO) Secretariat (WTO 2006) identified seven features of ASAs as relevant indicators of openness for scheduled air passenger services: (1) Grant of rights (air freedoms allowing airlines to provide services over designated markets) (1); (2) Capacity clause (regulation on volume of traffic, frequency of service, and/or aircraft types); (3) Tariff approval (whether fares need to be approved before applied); (4) Withholding (which defines the conditions for a foreign carrier to operate, such as ownership and effective citizen control requirements); (5) Designation (which governs the number of airlines allowed to serve the market between two countries and on specific routes); (6) Statistics (which requires the exchange of operational statistics between countries or their airlines); and (7) Cooperative arrangements (which regulate the cooperative marketing agreements between airlines). After reviewing 2,299 ASAs in International Civil Aeronautics Organization (ICAO) and WTO databases, Piermartini and Rousova (2008) indicated that the regulations used most frequently are on pricing, capacity, and cooperative arrangements. In addition, while 60 percent of the ASAs allow multiple designations, the remaining 40 percent permit only single designation.

Since the deregulation of its domestic airline industry, the U.S. government has also pushed for the liberalization of international air markets. In 1979, the United States enacted the International Air Transportation Competition Act, which formally laid down the principle of promoting liberalized bilateral ASAs with foreign countries. A major breakthrough was achieved when the first open-skies agreement was reached between the United States and the Netherlands in 1992, removing capacity and frequency constraints for aviation services between the two nations. As of November 25, 2008, the United States has open skies agreements (2) with 94 countries in six continents, making it the open-skies hub nation of the world (U.S. Department of State 2009).

During the time period of 1988 to 1997, three air transport liberalization packages were implemented by European Union (EU) countries, which eventually created a single aviation market for the EU community carriers by adding cabotage rights in 1997. As of January 11, 2007, a total of 66 countries in all continents recognized EU common market in their ASAs, allowing European air carriers to operate flights between any EU member states and these countries. In April 2007, the EU-U.S. Open Aviation Agreement (OAA) was signed and went into effect on March 30, 2008. While similar agreements are being negotiated with other nations, efforts are being made to further liberalize the international aviation market, which would remove remaining constraints such as ownership restriction.

Bilateral air services agreements remain the primary vehicles for liberalization of international air transport services for most countries. During the past decade, about one thousand bilateral air services agreements (including amendments and/or memoranda of understanding) were reportedly concluded. Over 70 percent of these agreements and amendments contained some forms of liberalized arrangements, such as expanded traffic rights (covering Third, Fourth and in some cases Fifth Freedom traffic rights), multiple designations with or without route limitations, free determination of capacity, a double disapproval or free pricing regime, and broadened criteria of airline ownership and control. As the airline business evolves, some of the recent bilateral air services agreements have included provisions dealing with computer reservation systems (CRSs), airline code sharing, and leasing of aircraft and intermodal transport. One notable development is the considerable increase in the number of bilateral "open skies" air services agreements, which provide for full market access without restrictions on Third, Fourth, and Fifth Freedom traffic rights, designation, capacity, frequencies, code sharing, and tariffs. As of February 2008, 142 bilateral "open skies" agreements have been reportedly concluded worldwide.

Despite the fact that many liberalization agreements have been reached over the years, liberalization of the international aviation market remains a formidable challenge. Even with strong political will, the negotiation of liberalizing ASAs remains a lengthy process full of disagreements and bargaining. Many of the difficulties in liberalization efforts can be ascribed to stakeholders' different expectations on the effects of alternative policy or agreement scenarios. The resulting uncertainty of liberalization has prevented many governments from adopting substantial regulatory changes, and has given certain interest groups, including national flag carriers, strong influence over the negotiation process. Therefore, there is a need to review the actual effects brought on by the liberalization process worldwide, and investigate the mechanisms leading to those changes. These efforts would, of course, facilitate policy makers in their efforts to address future liberalization initiatives.

This study aims to achieve the above objectives by investigating three important areas. In the next section, the economic effects of liberalization on the air transport industry and economy are reviewed. Then, the airline network competition and restructuring process with deregulation and liberalization is examined. The third area focuses on the impacts of low-cost carriers on airline networks and aviation policy. The last section summarizes and concludes the study.

ECONOMIC EFFECTS OF AIR TRANSPORT LIBERALIZATION

The evolving liberalization of international air transport regulation since the mid-1990s has played an important role in the growth of the air transport industry by providing a favorable regulatory environment. Worldwide, the total number of annual passengers has grown by 46 percent in the past 10 years, increasing from 1.457 billion passengers to 2.128 billion per year (ICAO 2007). The ICAO Secretariat (2007) estimated that, in 2006, about 31 percent of the country-pairs with non-stop passenger air services and about 49 percent of the seat capacity were offered between countries that have embraced liberalization either by bilateral "open skies" ASAs, or by regional or plurilateral liberalized agreements and arrangements. To put these figures in perspective, it is estimated that there were less than 4 percent and about 16 percent of the country-pairs with non-stop passenger air services in 1995 and 2000, respectively. About 20 percent and 42 percent of the seat capacity were offered in 1995 and 2000, respectively, between countries that have embraced liberalization. Numerous reports and papers from academia, governments, and industries confirmed that the liberalization efforts had brought significant welfare gains and economic growth worldwide.

This section provides an overview of the economic effects of regulation and liberalization. A short summary of the origin and results of regulation is given first. We then review the economic impacts of air transport liberalization on the aviation industry. Finally, a discussion on the relationships between air transport liberalization and overall economy is provided. While this article focuses on the liberalization of the international market, the U.S. regulation and deregulation process is also discussed where appropriate. This is because the regulation and deregulation practice in this market has served much as a prototype in the industry. In addition, the U.S. market has been extensively studied and rich results and findings have been obtained.

Rationale and Economic Effects of Air Transport Regulation

After World War I, some state-owned enterprises and private airlines began to offer commercial air transport services to the public. However, with low demand and high risk of operation, commercial air transport would not have been sustainable without government support. As a result, the Kelly Air Mail Act of 1925 was passed in the United States, allowing the U.S. Post Office to subsidize private air mail carriage by awarding contracts with payment exceeding air mail revenue on the routes. To oversee such a system, the Civil Aeronautics Board (CAB) was created as a regulator by the Civil Aeronautical Act of 1938. Charged with "the promotion, encouragement and development of civil aeronautics," CAB aims to eliminate "unfair or destructive competitive practice" by regulating entry, rate levels and structures, subsidies, and merger decisions (Caves 1962; Levine 1965; Borestein and Rose 2007).

Quite a few studies (Levine 1965; Jordan 1970; Keeler 1972) found that the regulations imposed by CAB resulted in limited competition and high fares. Levine (1987) pointed out that fares in unregulated intra-state routes tend to have relatively high service levels and load factors with remarkably lower fares. High fares maintained by regulation did not, however, lead to high industry profits. Airlines engaged in non-price competition with inefficiently high service quality (e.g., flight frequency, in-flight amenities) and newer, larger aircraft. This practice reduced airlines' load factors and increased average costs. In the years just prior to deregulation, the industry average load factors fell below 50 percent (Borestein and Rose 2007).

Similar patterns have been observed in the international market. The regulatory system on international air transport was formalized in the 1944 Chicago Convention. The United States, which was effectively the only country with sufficient financial resources, a large aircraft fleet, and expertise after the World War II, attempted to promote competition on a multilateral basis. However, such an effort was not successful. Following the precedent of the first U.S.-UK bilateral agreement in 1946 ("Bermuda I"), ASAs generally regulate services (passenger and cargo) and routes to be operated, and stipulate fare-setting mechanisms and capacity limits. In one sense, this bilateral system was an interesting solution to a competition issue; that is, countries at the time feared unilateral application of monopoly power by a trading partner. However, it introduced another set of competition problems by constraining entry, especially to routes between countries (Warren and Findlay 1998). All these regulations have greatly hindered the growth of international travel. Such a situation only began to change gradually with the passage of the 1979 U.S. International Air Transportation Competition Promotion Act (IATCPA), after which the United States began to explicitly promote liberalized bilateral ASAs with foreign countries.

As evidenced by the outcomes in both domestic and international markets, regulations were introduced with good intentions and objectives. Over time, however, policy makers found themselves drifting away from these original targets, with more and more regulations imposed to correct the undesirable effects of the predecessors. Many governments have realized that a better solution is to deregulate/ liberalize the market, which has brought very positive economic effects to the air transport industry as well as the overall economy.

Economic Effects of Liberalization on the Air Transport Industry

While the net effects of previous liberalization events vary across the markets, there are some common changes brought to the air transport industry, as follows.

Increased Competition, Reduced Price, and Traffic Stimulation Effects

Most liberalization efforts have brought significant traffic growth. Such traffic growth was mainly driven by two factors. First, liberalization removes constraints on pricing, route entry, service capacity, and cooperative arrangements among alliance members. Removal of these constraints allows airlines to compete more effectively and operate more efficiently, which reduces price and increases service quality in terms of flight frequency, frequent flier programs, etc. As a result, passenger traffic can be stimulated substantially. Secondly, liberalization allows airlines to optimize their network configuration. The implementation of hub-and-spoke networks enabled carriers to link small markets with their hub airports, thus expanding air services to new destinations. Maillebiau et al. (1995) developed a translog air travel demand function in a single aviation market in order to forecast the passenger increase between the United States and five European countries: UK, France, West Germany, Netherlands, and Italy. They estimated that traffic growth from liberalization is 56 percent with an average benefit of $585 per passenger. Their results also found a decrease in airline yield of 35 percent and an increase in accessibility of 44 percent.

This is not a surprising result. Button (1998) found that following the U.S. deregulation, during 1978-1988, passenger traffic increased by 55 percent while scheduled revenue passenger-miles grew by over 60 percent. The real costs of travel fell by about 17 percent on major routes. (3) Morrison and Winston (1986) estimated that the U.S. deregulation yielded welfare gains of $6 billion to passengers and profit gains of about $2.5 billion to stakeholders of carriers (including various labor unions). Table 1 compares the changes in prices of air travel versus other goods and services in the United States during the 1978-2006 time period. It shows that both domestic and international air services are two of the four items with the lowest nominal price increases during the 28-year period: 1.5-1.6 times the price of 1978 for air travel while CPI index more than tripled during the same period.

The U.S. Government Accountability Office (GAO) (2006) studied the effects of deregulation on airline competition and air fare in the U.S. domestic market. The study found that in 1980, the average number of competitors was 2.2 per market, which increased to 3.5 in 2005. During the same period, median fare declined almost 40 percent, as shown in Figure 1.

Productive Efficiency Improvement

Liberalization has improved productive efficiency of the airline industry in several ways. First, liberalization allows airlines to optimize their network and pricing strategy. This improves airlines' operation efficiency and average load factor. As a result, average costs have been reduced steadily. Secondly, the increased competition following liberalization forces airlines to relentlessly improve their efficiency. Less efficient airlines are either merged or bankrupted, while new business models and innovations (e.g., low-cost carriers, e-tickets, and self service check-in) are nurtured when firms drive to achieve competitive edge. Oum and Yu (1998) and Oum, Fu, and Yu (2005) found that after deregulation, many remaining U.S. carriers have achieved global leadership in cost competitiveness. Similarly, Fethi, Jackson, and Weyman-Jones (2000) found that the EU liberalization has improved airlines' efficiency significantly.

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Effects on Employment in the Aviation Industry As one would expect, the rapid growth brought by liberalization must lead to additional jobs in the aviation sector. Button (1998) estimated that with the substantial growth following U.S. deregulation, the employment in the air transport industry increased by 32 percent during the 1978-1988 period. InterVISTAS (2006) estimated that the creation of the Single European Aviation Market in 1993 produced about 1.4 million new jobs in aviation and related industries; the 1998 UK-UAE (United Arab Emirates) liberalization created over 18,700 full-time-equivalent positions in the UK side; and the 1986 Germany-UAE liberalization created 745 new full-time positions in UAE and 2,600 new jobs in Germany.

It should be noted that the job creation process sometimes is accompanied by job relocation when firms outsource certain functions to more cost-effective regions. For example, with the liberalization/formation of the European single aviation market, Lufthansa (LH) began to outsource certain functions to Eastern European countries. In 2005, LH built a new shared customer services center in the Czech Republic, and set up maintenance facilities for heavy checks in Hungary. The airline also plans to move most of its accounting and purchasing operations to Poland. In addition to cost cutting, outsourcing strategies are likely driven by the company's desire to explore overseas opportunities. While outsourcing operations abroad will reduce domestic production, a more competitive airline in the global market will achieve more service export for the country (e.g., Clougherty and Zhang 2008).

Air Transport Liberalization and Overall Economy

There is a two-way relationship between air transportation and the overall economy. It has been well recognized that air transport and logistics, like other transport services, are so-called "derived" demands. They are usually purchased as inputs or intermediate products for the consumption and production of some other services. Passengers purchase air service because they need to go to the destination for business or leisure, whereas cargos are shipped such that they can be consumed or processed at the destination. Therefore, the demand for transport services is largely driven by the overall economy. Boeing (2008) attributes about two-thirds of traffic growth to the GDP growth, and the rest to other factors such as increasing trade, lower costs, and improved services. ICAO estimated the income elasticity for air travel to be 1.27. That is, ceteris paribus, a 1 percent increase in GDP will lead to a 1.27 percent increase in air travel.

While air transport is driven by the global economy, it is in itself an important driver for the global economy. The International Air Transport Association (IATA) 2005 annual report noted that air transport directly employs four million people worldwide and generates $400 billion in output. In addition, the efficiency and quality improvements in air passenger services contribute to the growth in sectors such as hotel and tourism. The free flow of people and information, together with improved air cargo operations, promote trade and improve the efficiency of the overall economy. That is, the aviation sector imposes significant positive externalities to other industries, contributing to economic and employment growth. Button et al. (1999) examined the link between high-tech employment in a region and whether the region is served by a hub airport. Using data from 321 U.S. metropolitan areas in 1994, the analysis found that the presence of a hub airport increased high-tech employment by an average of 12,000 jobs in a region. Irwin and Kasarda (1991) examined the relationship between the structure of airline networks and employment growth in 104 metropolitan areas in the United States. They found that expansion of the airline network serving a region had a significant positive impact on local employment. The effect was particularly significant in the service sector. Furthermore, analysis using nonrecursive models confirmed that increases in the airline network were a cause rather than a consequence of this employment growth. In addition to job creation, air transport facilitates commerce communication and labor mobility. Button (2006) pointed out that in the United States and Europe, more than 40 percent of air travel is for business purposes. The remaining trips are either for leisure or for visiting friends and relatives. Leisure travel promotes the hotel and tourism sectors, while visiting trips provide the basis upon which social ties are retained and, as such, allow for an efficient and integrated labor market.

Air transport is ideal for the coordination of global supply chains, and thereby improves the overall efficiency of the economy. As firms source around the world for most favorable inputs such as labor, land, technology, and capital, manufacturing and factory locations can be sparsely distributed. Hummels (2006) found that the elasticity of air shipping costs with respect to distance declined dramatically, decreasing from 0.43 in 1974 to 0.045 in 2004. That is, doubling distance shipped caused a 43 percent increase in air shipping costs in 1974, but only a 4.5 percent increase in air shipping costs in 2004. As a result, the average air shipment is getting longer and the average ocean shipment is getting shorter. (4) Recent papers by Aizenman (2004) and Schaur (2006) argued that air shipping may be an effective way to handle international demand volatility. Because air shipments take hours rather than weeks, firms can wait until the realization of demand shocks before deciding on quantities to be sold. That is, air shipping provides these firms with a real option to smooth demand shocks.

Like improvements of other shipping modes, the efficiency and quality improvements of air transportation promote trade and economic growth. Two major barriers for trade are cost and time related to transportation. Limao and Venables (2001) found that a 10 percent increase in transport costs reduces trade volume by 20 percent. Recent studies found that a 10 percent increase in time reduces bilateral trade volumes by between 5 percent and 8 percent (Hausman et al. 2005; Djankov et al. 2005). While air transport is clearly superior to other shipping modes in terms of speed, its perceived cost disadvantage has been reduced over the years. Swan (2007) found that since 1970, both price and production cost for air travel have been declining at about 1 percent annually. As shipments are of higher value and lighter weight, the ad valorem cost of air freight, i.e., the transport cost needed to move a dollar of goods, is also decreasing. Harrigan (2005) estimated that the relative cost of air transport has declined by 40 percent between 1990 and 2004. As a result, air cargo is of growing importance in cargo logistics, accounting for about 40 percent of international trade by value. Many countries have chosen to locate special economic zones and high-tech parks near airports.

Some nations, such as the Netherlands and Singapore, achieved rapid economic developments by leveraging their liberalized transport systems. Compared to its European neighbors such as France and Germany, the Netherlands has a relatively small domestic market. Nevertheless, the country has been aggressive in liberalizing its transport sectors. In 1992 it signed the first open skies agreement in the world with the United States, promoting Schiphol airport as a major gateway for cross-Atlantic traffic, while facilitating its flag carrier at the time, KLM, to further expand its network coverage in Europe and North America. These efforts, together with its superior transport infrastructure of marine ports, rail, and road, (5) have made the Netherlands not only a major European aviation hub nation, but also an ideal place to establish European Distribution Centers (Oum and Park 2004). In terms of value, only 5 percent of the express cargo and retail logistics handled in the Netherlands is for local consumption (Datamonitor 2005). With the establishment of their European Distribution Centers, many companies have chosen to also locate their billing centers, service depots, research centers, or even European headquarters in the country. The well developed transport and logistics sector in the Netherlands has clearly enhanced the overall competitiveness of its economy.

AIRLINE NETWORK COMPETITION AND LIBERALIZATION

In markets not yet liberalized, there can be many constraints on airlines' network configuration. Bilateral ASAs between two countries limit airports and route access, flight frequency, and seat capacity. These regulations prevent carriers from optimizing their overall networks. The limitations imposed with a third country (i.e., limitations on beyond rights such as Fifth Freedom) will further constrain a carrier's network structure in a region. As many theoretical and empirical studies found, when these constraints are removed, airlines often choose to reconfigure their networks to achieve various objectives, among which are to improve cost efficiency by exploiting "economies of traffic density," (6) to enhance service quality by initiating direct flights and/or by increasing flight frequency, (7) and to price more aggressively or to compete more strategically. (8) Many of these objectives are achieved by streamlining a carrier's multi-hub network.

Effects of Hub-and-Spoke Networks and Airline Network Competition

The emergence and prevalence of hub-and-spoke (HS) network is one of the most common developments in deregulated markets, especially for airlines endowed with access rights to a single large market such as the United States and European Single Aviation Market. The formation of a hub-and-spoke network can affect both demand and cost.

The effect of hubbing on costs has been extensively studied in the literature (e.g., Caves et al. 1984; Brueckner and Spiller 1994; Hendricks et al. 1995, 1999). Costs can go down due to higher traffic densities in HS operations than in fully connected (FC, or point-to-point) operations, although these cost savings might be offset by the travelers' circuitous routings via hubs.

Hubbing can also affect demand (which, in turn, affects revenues and profits) with its effect on passenger travel time and schedule delay time. Compared to non-stop services, an HS network increases the average passenger's travel time due to the extra connecting time at hubs and the circuitous routing of passenger trips. On the other hand, HS reduces a passenger's schedule delay time-i.e., the time between his desired departure and the actual departure time (Douglas and Miller 1974)--by offering increased flight frequency. In addition, an HS network allows an airline to serve many additional city-pairs when a new spoke route is added to the network (Oum and Tretheway 1990).

The HS network is an efficient way to serve destinations over large spatial distances. Airbus (2007) pointed out that one source of connecting traffic is passengers who could in fact fly directly if they wanted to. For example, in 2006, 20 percent of those flying between Europe and Asia selected a connecting route, even though they could have taken a direct service. There are several reasons for this behavior. Many passengers prefer connecting services to direct service due to the wider variety of schedules offered at major hubs, either in terms of flight frequency or number of destination cities. Airlines often offer lower prices for connecting services, which is a by-product benefit from global airline alliances (e.g., Oum et al. 2000). Passengers may also choose to fly via a hub to take advantage of a stay-over at an intermediate stop.

Airlines may form HS networks as a strategic response to competitors rather than to simply save costs. Oum, Zhang, and Zhang (1995) show that hubbing can be used as both an offensive and a defensive strategy in airline network rivalry. Another major benefit of HS networks is associated with a carrier's dominance at its hub airports, which allows it to achieve substantially higher mark-up above costs. Such a benefit to the dominant carrier is referred to as the "hub premium" in the literature, as has been confirmed in numerous studies including Borenstein (1989), Dresner and Windle (1992), Morrison and Winston (1995), Lee and Prado (2005), GAO (1989, 1990), Lijesen, Rietveld, and Nijkamp (2004), and DOT (2001). Such a benefit gives airlines a strong incentive to dominate an airport. Table 2 shows that during the fifteen years after U.S. domestic airline deregulation in 1978, all major network carriers have strengthened their market shares at their respective hubs.

In conclusion, the prevalence of HS networks after airline deregulation can be explained by cost advantages in production (economies of density) and/or revenue advantages achieved via demand stimulation (network complementarity). Even when there is neither cost nor revenue advantage, the threat of potential entry alone can give rise to an HS network as opposed to an FC network. Zhang (1996) further argues that, for strategic reasons, competing airlines would choose to develop HS networks using different hub airports.

Upon deregulation in 1978, major U.S. carriers began to strategically plan their networks to strengthen their dominance in existing hubs and to expand continental market coverage. Such a process was accompanied by massive mergers, acquisitions, and liquidations. For example, many airlines based in Central and Eastern United States acquired carriers based in Western United States. (9) This trend resulted in a massive consolidation of the industry, which reduced the number of trunk airlines from over 25 before the 1978 deregulation to six major national network carriers. As a result, all of the national network carriers have built up multiple hub networks in the United States.

While network carriers often use multiple hubs, they cannot afford to have more than one hub in a region. Airneth (2005) observed that the closest distance between two major hubs in a successful dual-hub system in the United States is 900 kilometers (km), the case of Northwest's Minneapolis-St. Paul and Detroit. In 2008, Delta Airlines acquired Northwest, with a plan to reduce or close the hub functions of Memphis (NW's hub) and Cincinnati (Delta hub), since they are too close to the Atlanta and Detroit hubs of the combined carrier. This restructuring would result in a network of four hubs in North America: Atlanta, Detroit, Minneapolis-St. Paul, and Salt Lake City. U.S Airways has also drastically reduced the hub functions of Pittsburgh in the last five years since it is close to its own hub in Washington Reagan International Airport.

Airline Network Development and Policy Implication

If domestic and international markets are both fully deregulated, network carriers would be able to expand their multi-hub networks to global markets. Intercontinental mergers and acquisitions are likely to occur since they are usually cheaper and less time-consuming than developing a carrier's own network in other continents (Oum, Taylor, and Zhang 1993). The current discussions between the European Commission and the United States on deregulating foreign ownership of airlines would have similar effects as a complete deregulation. In fact, such an agreement that aims to dismantle the limitations on foreign ownership may eventually lead to a complete dismantling of the bilateral ASA system.

Under the gradual liberalization scenario, there will be several driving forces for airlines to restructure their networks. First, full-service airlines (FSAs) will consolidate via merger and acquisitions in domestic and intra-continental markets, in order to strengthen their networks and market positions in a continent. Second, network and market linkages across different continents will be strengthened via global strategic alliances (Oum, Park, and Zhang 2000), as evidenced by the formation and growth of major airlines alliances such as STAR, SkyTeam, and OneWorld. Since the airlines within each Strategic Alliance Group will retain their own identity, they will structure their networks in such a way that their own profits are maximized. As a result, these airlines' international and intercontinental networks will be influenced heavily by the structure of their domestic and continental networks.

Previous alliance studies suggest that international alliances lowered fares, grew the market, and improved partners' operations and ser(10) vice quality. (10) However, the future of these global alliances is not crystal clear. Since the existing alliances grew under a web of restrictive bilateral ASAs which barred cabotage and foreign ownership, they represented a "second best" approach to the realization of inter-firm synergies on both the cost and demand sides. (In effect, such realization is constrained by the existing restrictive international regimes; as a consequence, the observed benefits from alliances are lower than their full potential.) Therefore, the future growth of global airline alliances would be limited, if not approaching zero, under a fully liberalized (both domestically and internationally) air transport market.

When restrictions on route entry, capacity, and frequency are dropped in domestic and intra-continental markets, network reconfigurations are likely to be different among carriers operating in United States, Europe, and Asia. The U.S. carriers have had complete freedom to restructure their domestic networks since 1978. Transborder open skies in Europe began in 1993, and the complete single market (including cabotage rights for all EU carriers) began in 1997. As a result, European airlines had less time to adjust their networks compared to their peers in the United States. Most crossborder markets in Asia are still heavily regulated. As a result, most of the Asian carriers serve their principal city markets, rather than using their super airports as hubs. Such network patterns can be seen in Table 3. Many U.S. airports serve as real hubs, with over 50 percent connecting ratios. In Europe, only the Frankfurt airport has more than a 50 percent connecting ratio. All other airports, including London, Amsterdam, and Paris, have less than 50 percent connecting ratios. The Asian airports perform even fewer hub functions. Even the most active hub airport in East Asia, Hong Kong, has only slightly higher than a 30 percent connecting ratio. (11) Many Asian carriers are taking advantage of the restrictive international regulatory regime since, with capacity restricted, airlines are able to charge higher prices to local traffic. Therefore, they have less incentive to use the scarce intra-Asia capacity to attract connecting passengers. In 2007, Narita and Incheon airports have only 17 percent and 12 percent connecting ratios respectively. As the international liberalization advances further and perhaps more rapidly in the future, Asian network carriers are likely to restructure their network and traffic routing patterns in such a way that functions of their major airports are increased.

The varying stages of openness in global aviation markets imply that airline networks, and accompanying traffic flows, will experience a shift in spatial pattern and market power. For example, Hong Kong had been much more liberalized than the neighboring economies, including mainland China, Taiwan, Thailand, and Vietnam. Together with its fast-growing economy, Hong Kong had secured leadership for its airports and marine ports in the region. However, with the gradual liberalization in mainland China, Hong Kong airport's hub status is facing serious challenges from nearby airports such as Guangzhou and Shenzhen. Since South Korean air carriers lost most of their domestic markets to high-speed rail, KTX, the country has no choice but to adopt a Singapore-style policy to promote open skies regimes internationally, especially with China, Japan, and Southeast Asian countries. It is worth noting that South Korea has had open skies ASA with the United States since 1998.

Due to historical reasons, Japan gave major bases of operations at Narita and other major Japanese airports to United Airlines, Northwest Airlines, and Federal Express, and opened its markets to other U.S. carriers substantially. However, the Japanese government now realizes that the importance of economic integration with China and South Korea, and thus, the open skies regime in Northeast Asia, is a more urgent task than signing open skies with the United States or Canada. Since both Tokyo-Narita and Tokyo-Haneda airports are expected to have substantially more slots in 2010, Japan expects to allocate a lion's share of these increases to Asian carriers, especially carriers of the Northeast Asian subcontinent. An issue that worries Japanese government is that there has been an increasing trend that Northeast Asia-North America air traffic is bypassing Tokyo-Narita (NRT), as shown in Figure 2.

Even for countries with deregulated air transport markets, it is important to maintain their leadership in liberalization to keep their aviation sector competitive in the global market. Singapore, for example, has been working hard to maintain its leadership in the region in terms of air transport liberalization. As of 2006, Singapore has signed over 90 ASAs with other countries, compared to the 57 ASAs signed by Hong Kong. (12) Singapore also reached open-skies agreements with the United States, New Zealand, and the United Arab Emirates. In June 2006, the country became the first Asian nation to sign an open skies agreement with the EU, which allows Singapore Airlines to fly anywhere within the 27 EU-nation bloc. Such an aggressive and determined liberalization policy had helped the nation to maintain the competitiveness of its airports and airlines.

IMPACTS OF LOW-COST CARRIERS AND IMPLICATIONS ON AVIATION POLICY

A strong trend that emerged with deregulation and liberalization in the United States, Canada, and Europe was the simultaneous occurrence of the birth of upstart competitors and the disappearance of weaker airlines through bankruptcies or mergers. Well established brands like Pan American World Airways (PanAm), Eastern Airlines, Trans World Airlines (TWA), and Canadian Airlines International disappeared, while LCCs such as Southwest and several new brands (e.g., JetBlue, Westjet, Ryanair, Easy Jet) emerged and prospered. As pointed out by the Transportation Research Board (1999), "Probably the most significant development in the U.S. airline industry during the past decade has been the continued expansion of Southwest Airlines and the resurgence of low-fare entry generally." (13) The "Southwest effect--i.e., a rapid increase in traffic volume and a simultaneous fall in fares on routes where, or close to where, Southwest Airlines operates--has become widely known (U.S. DOT 1993; Richards 1996). The price effects of LCCs were empirically estimated by, among others, U.S. DOT (1993), Windle and Dresner (1995), Dresner et al. (1996), and Morrison (2001). (14) Franke (2004) suggested that Europe has a similar "Ryanair effect," whereas Zhang et al. (2009) suggested that the "Southwest effect" might also exist in Asia.

LCCs such as Southwest Airlines and Ryanair grew under a deregulatory domestic environment. In Europe, after the EU integration in the mid-1990s, the EU internal market has become a "domestic" market. In Asia, entry of LCCs was facilitated by domestic deregulations as well. While deregulation and liberalization have facilitated the growth of LCCs, the LCC experience has also promoted policy reform and liberalization. Until 1978, the U.S. airline industry was regulated by the Civil Aeronautics Board. It was mainly through the experience of unregulated Southwest Airlines--which offered lower fares for intra-state (Texas) services than comparable regulated services between states--that the deregulation of market entry commenced in 1978 with the passage of the Airline Deregulation Act (Levine 1987; Morrison 2001). This has, in turn, stimulated Southwest's domestic expansion as the state borders no longer mattered.

[FIGURE 2 OMITTED]

Another case in which the LCC experience stimulates policy liberalization is the Association of Southeast Asian Nations (ASEAN) region, where significant progress has been made lately. In July 2007, ASEAN countries reached an agreement under which unlimited flights between capital cities in ASEAN would start at the end of 2008. Furthermore, it was expected that ASEAN nations would sign an open skies agreement as early as December 2008 (Asia Times 2008). These positive policy developments are due mainly to the positive effects of liberalization, both domestically and regionally, and of emerging LCCs. Consider the case of Malaysia. After maintaining a strict closed skies aviation policy for many decades, Malaysia has recently seen a boom in air traffic growth due to greater domestic competition led by AirAsia. This air traffic growth, together with the success of other regional LCCs, has prompted the Malaysian and other ASEAN governments to push for a more liberalized regulatory regime (Asia Times 2008). Another major motivation for liberalization in these Southeast Asian countries is to boost tourism and business travel after the devastating Asian financial crisis in the late 1990s. (15) *FN0* As a case of regional liberalization, consider the lucrative Singapore-Kuala Lumpur route. This route had for years been restricted by Malaysia to protect Malaysian Airlines, and was dominated by Malaysian Airlines and Singapore Airlines as a duopoly. In late 2007, the Malaysian government decided to allow AirAsia to operate on the route, paving the way for Tiger Airways (from the Singaporean side) to enter the route as well. The liberalization policy started with allowing two flights daily from each LCC, and then was extended to six daily flights in September 2008. As illustrated in Zhang et al. (2009), the entry by AirAsia and Tiger Airways forced the two incumbent FSAs to significantly lower their fares, to the clear benefit of passengers.

Dobruszkes (2009) investigated airline competition in Europe following the liberalization in 1997. He found that traditional European airlines, especially the majors (Air France, British Airways, Lufthansa, and KLM) have not benefited directly from the liberalization of European airspace in order to operate flights not centered on their country of origin. Their contribution to the usage of the 5th-9th Air Freedoms in Europe is less than 1 percent each. These carriers make greater use of the 5th-9th Freedoms outside Europe, in particular on long-haul flights to the Far East that involve a stopover. In Europe, these carriers remain strongly rooted in their national centers. It is LCCs that have benefited most from the new air freedoms made available by the liberalization, as shown in Table 4. Dobruszkes (2009) suggests that this benefit may be due to the new mode of operation by LCCs, which facilitates the development of extra-national bases.

Another important channel via which LCCs promote further policy liberalization is through the enhancement of the competitiveness of national carriers. Clougherty and Zhang (2008) identify three paths via which domestic rivalry (domestic competition) might influence international performance on the part of airlines. First, when there is an equivalence between the number of domestic and international competitors (that is, every domestic airline also serves international markets), then increasing the number of domestic competitors also increases the number of international competitors representing the nation. Accordingly, a strategic effect of having multiple national competitors in world markets is enhanced exports. Second, a "joint economies of production" effect derives from the impact of domestic rivalry on the size of an incumbent firm's domestic operation, since size of domestic operation affects international performance in the airline industry (Clougherty 2002, 2006). Third, domestic rivalry may also pressure firms to improve product quality and/or productivity, thus enhancing the competitiveness of home-nation airlines in international markets. In short, an additional rationale behind domestic deregulation and competition could well be the promotion of domestic carriers' competitiveness in international markets. Accordingly, the dramatic growth in domestic competition due to LCCs may significantly impact international competitive outcomes.

The large economic benefits of LCCs are so visible that their further developments tend to speed up the deregulation/liberalization process of domestic and international airline markets. On the other hand, as discussed in Zhang et al. (2009), there are still a large number of visible and invisible barriers acting against growth of LCC activities in markets where LCCs are most needed. (16) The organizational structure of AirAsia, arguably the most successful LCC in Asia, shown in Figure 3, serves as telling evidence of restrictions for an Asian LCC to grow its services across national boundaries. In particular, given the restricted aviation regime in the region, AirAsia could extend its network and enter a new regional market only through joint venture (JV) arrangements or alliances: Thai AirAsia in Thailand and Indonesia AirAsia in Indonesia are two JV examples in which AirAsia holds a 49 percent share, so as to abide by the national ownership restrictions of Thailand and Indonesia respectively.

More recently, Tiger Airways (of Singapore) tried to establish JVs, namely, Tiger Airways Australia and Incheon Tiger Airways, in an attempt to expand its services to Australia and South Korea, respectively. While the Australian JV is in operation, the Korean project was called off in late December 2008 after more than one year of planning, citing the "regulatory uncertainty" in Korea and a weak global economy as reasons for the cancellation. The project would have been a tie-up with Incheon Metropolitan City, with the Singapore company taking a 49 percent stake. But from day one, the project faced local opposition. In August 2008, Korean LCCs (namely, Air Busan, Yeongnam Air, Jeju Air, and Jin Air), jittery about the impending competition, filed a complaint with their country's Ministry of Land, Transport and Maritime Affairs. They urged the government to put the brakes on the launch of the new carrier, claiming that it would in effect be controlled and run by Tiger since the other shareholders had no airline experience. The airlines went so far as to say that the new airline would "attack Korea's aviation sovereignty" (The Straits Times 2008).

[FIGURE 3 OMITTED]

The experiences from North America and Europe suggest that the benefits brought by LCCs are concrete, dramatic, and lasting, and that they form a significant part of the gains from air transport liberalization. However, to fully gain such benefits, liberalization and deregulation need to be carried out.

SUMMARY AND CONCLUSION

As early as the system of bilateral ASA was adopted as the primary regulatory system for international air transport at the Chicago Convention in 1944, there have been proposals to liberalize the international aviation market. It took the world nearly one half of a century before the first open skies bilateral ASA was signed by the United States and the Netherlands in 1992. Although many open skies agreements have been reached in the following years, liberalization of international air transport remains a formidable challenge. In addition, many of these liberalizations have been partial and incomplete, mostly requiring further deregulation of foreign ownership, beyond rights, entry, and other factors. Many of the difficulties facing liberalization issue can be attributed to the stakeholders' different expectations about the effects of alternative policies and agreements. The resulting uncertainty has prevented many governments from adopting substantial regulatory changes. This study examined the effects of past liberalization policies on economic growth, passenger traffic, and low-cost carriers. While the actual effects of liberalization are subject to the influences of many factors, including the country's domestic market size, competitiveness of home carriers, and even geographic location of major hub airports, some general conclusions obtained from our investigation can be summarized as follows:

Liberalization has led to substantial economic and traffic growth. Such positive effects are mainly due to (1) increased competition in the aviation market, which reduces price and stimulates traffic growth; (2) productive efficiency gains as a result of carriers' optimization of their route network and pricing strategy as well as due to the increased competitive pressure to improve productivity to survive: and (3) positive externalities generated to the overall economy, including promotion of employment opportunities, trade, and tourism, and better transport and logistics services. These impacts are not uniform across countries. However, an increasing number of countries have adopted progressive liberalization, suggesting that the countries involved have benefited from liberalization in general.

Liberalization allowed carriers to optimize their networks to cover intra- and inter-continental markets. Hub-and-spoke networks have been used extensively by airlines to achieve revenue advantage and/or cost advantages in production through economies of density. If foreign ownership and control restrictions are relaxed, market consolidation via merger and acquisition would allow airlines to strengthen their networks and market position. Strategic alliances allowed airlines to achieve "second best" network connection in markets where bilateral ASAs are still restrictive. Upon liberalization, the future growth of global airline alliances would be limited. Liberalization and network competition in international markets lead to shifts in the spatial pattern of traffic flow as well as reducing market power of dominant carriers. Therefore, it is important for forward-looking countries to maintain their leadership in liberalization so that they may be able to induce traffic flow patterns to shift in their favor.

The rapid growth of LCCs has brought significant impacts to the airline industry. There is a two-way relationship between LCC expansion and liberalization (and deregulation). Liberalization has increased competition and reduced air fares, which in turn has stimulated traffic substantially. These changes call for removal of restrictions on capacity, frequency, pricing, and entry. In liberalized markets such as the EU single aviation market, LCCs have benefited most from the deregulation of beyond traffic rights, which give them freedom to establish airport bases in foreign countries. In addition, development of LCCs in domestic markets can promote liberalization policy by increasing the competitiveness of a nation's airline industry as a whole. On the other hand, existing regulations on route entry, foreign ownership, and effective citizen control have constrained expansion of LCCs. These existing regulations thus prevented the associated benefits of liberalization policy to its citizens and economies from being fully realized.

The possibility of creating "destructive" or "excessive" competition has often been used as an excuse for maintaining regulation and/or for slowing the inevitable course of deregulation. Our investigation revealed that such regulatory protection of flag carriers did not lead their airline industry to efficiency and profitability, as policy makers had hoped. Instead, countries spearheading deregulation and liberalization scored various long-term benefits to their aviation industry as well as gained benefits for their consumers and overall economy in a major way. Therefore, we suggest that it is important for the first-mover countries to maintain their leadership in liberalization. In addition, it is urgent for countries still practicing regulatory protection of their flag airlines to abandon these practices and change their policy to use airlines to the benefit of their consumers and economy.

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ENDNOTES

(1) For the official definition of the freedoms of the air, the reader is referred to the Manual on the Regulation of International Air Transport, or the International Civil Aviation Organization (ICAO) Web site at http:// www.icao.int/icao/en/trivia/freedoms_air.htm.

(2) The precise definition of "open skies agreement'" differs across countries. In general, it broadly refers to ASAs that remove most of the constraints discussed at the beginning of this article, particularly constraints on pricing, capacity, designation of airlines, and entry on the 3rd/4th Freedom markets. The U.S.-style open skies also include exchange of unlimited 5th Freedom rights. The Current Model Open Skies Agreement used by the United States is available at http://www.state.gov/e/eeb/tra/ata/.

(3) Borenstein and Rose (2007) found that between 1976 and 1986, the U.S. average domestic passenger yield declined in real terms at a rate of 3.4 percent per year, while revenue passenger miles increased at a rate of 8.2 percent per year. However, they pointed out that the price effects of U.S. deregulation may have been overestimated. Instead, a major change was an increase in price dispersion. Price dispersion within carrier-routes more than doubled between 1979 and 2001.

(4) Hummels (2006) pointed out that ocean-shipped cargo traveled an average of 2,919 miles in 2004, down from 3,543 miles in 1975. In contrast, air-shipped cargo traveled an average of 3,383 miles in 2004, up from 2,600 in 1975.

(5) The Netherlands has the largest marine port in Europe (Rotterdam), superior inland river shipping to Germany and France, and extensive high-speed rail and road connections to Western Europe.

(6) See, e.g., Caves et al. (1984) and Brueckner and Spiller (1994). Traffic density is calculated by dividing the total traffic volume by the carrier's network size. Network size is usually defined as the number of origin-destination pairs served by the carrier, or the number of nodes connected in its network.

(7) See, e.g., Morrison and Winston (1987), Berechman and Shy (1998), Brueckner and Zhang (2001), and Brueckner (2004).

(8) Borenstein (1989), Spiller (1989), Berry (1990), Bittlingmayer (1990), Brueckner and Spiller (1991), Brueckner et al. (1992), Zhang and Wei (1993), Oum et al. (1995), Zhang (1996), and Hendricks et al. (1997, 1999).

(9) For example, Delta acquired Western Airlines in order to expand its market coverage in the western United States and to secure Salt Lake City as its western hub. American Airlines strengthened its Dallas-Ft. Worth hub and acquired Air California. U.S. Air acquired Piedmont and Pacific Southwest. On the other hand, Northwest acquired Republic in order to increase dominance of its Minneapolis-St. Paul hub and surrounding markets.

(10) For instance, the global alliances have facilitated competition among alliance networks, which significantly improved the efficiency of the international interlining market. Brueckner and Whelen (2000) found that fares are about 18-20 percent lower on international alliance and interlining routes.

(11) Hong Kong International Airport provides extensive connection services via ferry, rail, and shuttle buses to cities in the nearby Pearl River Delta region of mainland China. Although such connections expand the catchments area of the airport, they enhance the status of Hong Kong as an aviation hub very little. The major benefits brought by aviation hubs, such as cost savings or competitive advantages, are not fully realized.

(12) It should be noted that the number of ASAs signed is not the sole indicator of market openness, since some ASAs signed may not be active. In addition, compared to other Asian economies, Hong Kong has much better access to mainland China, a large and fast-growing market.

(13) This statement was also quoted at the beginning of Morrison (2001).

(14) See Tretheway and Kincaid (2005) for a literature review on the effect of LCCs on air fares in the United States.

(15) It is also interesting to note that statistics from the Tourism Office of Macau Government shows that after Viva Macau, a LCC, flied to Indonesia, Australia and Japan, visitor arrivals by air from these three countries have grown by 71 percent, 290 percent, and 300 percent, respectively.

(16) In addition to the policy issues discussed in this section, availability of suitable secondary airports also play important roles in the success of LCCs. Murakami (2007) pointed out that Japanese LCCs, which achieved slow growth in recent years, had limited access to secondary airports. The usage of expensive and congested Hong Kong International Airport may also have contributed to the failure of Oasis Airlines, a short-lived LCC based in Hong Kong.

Mr. Fu is assistant professor, faculty of business, The Hong Kong Polytechnic University, Kowloon, Hong Kong, China: email lgtxfu@polyu.edu.hk. Mr. Oum is UPS Foundation Chair in Transportation, Sauder School of Business, University of British Columbia, Vancouver, British Columbia, Canada: email tae.oum@sauder.ubc.ca. Mr. Zhang is Vancouver International Airport Authority Professor ill Air Transportation, Sauder School of Business, University of British Columbia; email anming.zhang@sauder.ubc.ca. The authors would like to thank the participants in the 2009 Sydney OECD- ITF (International Transport Forum) Conference and IFSPA 2009 Hong Kong Conference for helpful comments. Financial support from the OECD-ITF, Social Science and Humanities Research Council of Canada (SSHRC), and Hong Kong RGC Public Policy Research Grant (PolyU5002-PPR-5) are gratefully acknowledged. Special thanks to Zhuo Lin for his assistance in this study.
Table 1. Price Changes of Air Travel versus Other Goods and Services

Item-U.S. Good or Service Unit 1978 1990

College tuition: public Year $688 $1,908
College tuition: private Year $2,958 $9,340
Prescription drugs Index 61.6 181.7
New single-family home Home $55,700 $122,900
New vehicle Vehicle $6,470 $15,900
Unleaded gasoline Gallon $0.67 $1.16
CPI (Urban-all items) CPI-U 65.2 130.6
Movie ticket Ticket $2.34 $4.22
First-class postage Stamp $0.15 $0.25
Whole milk Index 81.0 124.4
Grade-A large eggs Dozen $0.82 $1.01
Air travel: international Mile 7.4 cents 10.83 cents
Air travel: domestic Mile 8.4 cents 13.43 cents
Television Index 101.8 74.6

Item-U.S. Good or Service 2006 Growth

College tuition: public $5,836 8.5x
College tuition: private $22,218 7.5x
Prescription drugs 363.9 5.9x
New single-family home $246,500 4.4x
New vehicle $28,450 4.4x
Unleaded gasoline $2.59 3.9x
CPI (Urban-all items) 201.6 3.1x
Movie ticket $6.55 2.8x
First-class postage $0.39 2.6x
Whole milk 181.6 2.2x
Grade-A large eggs $1.31 1.6x
Air travel: international 11.85 cents 1.6x
Air travel: domestic 13.00 cents 1.5x
Television 22.3 0.2x

Sources: General Accountability Office (2008), "Airline Industry:
Potential Mergers and Acquisitions Driven by Financial and
Competitive Pressures," GAO-08-845, July 31.

Table 2. Increased Share of the Dominant Carriers at Concentrated
Hub Airports, 1978-1993

 1978 1993

Airport Share Carrier Share Carrier

Atlanta 49.7 Delta 83.5 Delta
Charlotte 74.8 Eastern 94.6 USAir
Cincinnati 35.1 Delta 89.8 Delta
Dayton 35.3 TWA 40.5 USAir
Denver 32.0 United 51.8 United
Detroit 21.7 American 74.8 Northwest
Greensboro 64.5 Eastern 44.9 USAir
Memphis 42.2 Delta 76.3 Northwest
Minneapolis-St.
Paul 31.7 Northwest 80.6 Northwest
Nashville 28.5 American 69.8 American
Pittsburgh 46.7 Allegheny 88.9 USAir
Raleigh-Durham 74.2 Eastern 80.4 American
St. Louis 39.4 TAW 60.4 TWA
Salt Lake City 39.6 Western 71.4 Delta
Syracuse 40.5 Allegheny 49.5 USAir

Source: Morrison and Winston (1995)

Table 3. Percentage of Connecting Passengers at
Major Airports, 2007

Airport % Connecting Passenger

North America

ATL 64.0%
CLT 30.0% *
DEN 43.0%
DFW 60.0%
DTW 48.4%
EWR 30.6%
IAD 20.7% *
IAH 51.2%
JFK 30.8%
LAS 12.9% **
LAX 3.9%
MDW 25.0% **
MEM 63.3%
MIA 39.0%
MSP 47.3%
ORD 68.0% **
PHL 37.0% *
PIT 14.0%
SEA 28.0%
SFO 24.9%
SLC 50.4%
STL 23.9%

Europe

AMS 41.3%
ARN 22.0%
ATH 21.0% *
CDG 32.0% **
CPH 27.8%
FRA 53.0%
LHR 36.0% **
PRG 20.3% *
VIE 31.9%
ZRH 33.8% *

Asia

CAN 20.1%
HKG 33.3%
ICN 12.1%
NRT 17.2%
PEK n.a
PVG 16.3%
TPE 11.0%

Source: The ATRS Airport Benchmarking Report, 2005-2007
* 2006 data ** 2005 data

Table 4. Contribution of LCCs to the Use
of 5th-9th Freedoms

(Europe 2005, excluding SAS from the total)

Air Freedoms Flights Seats

5th 0% 0%
6th 0% 0%
7th 63% 77%
8th 0% 0%
9th 24% 47%
Total 53% 71%

Source: Dobruszkes (2009)
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Author:Fu, Xiaowen; Oum, Tae Hoon; Zhang, Anming
Publication:Transportation Journal
Geographic Code:9SING
Date:Sep 22, 2010
Words:11290
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