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DECISION MODELS FOR AIRLINE
PASSENGER AND CARGO
NETWORK ALLIANCES




LANG CHUNMEI






DOCTOR OF PHILOSOPHY

CITY UNIVERSITY OF HONG KONG

FEBRUARY 2006



CITY UNIVERSITY OF HONG KONG


Decision Models for Airline Passenger
and Cargo Network Alliances


Submitted to
Department of Management Sciences

in Partial Fulfillment of the Requirements
for the Degree of Doctor of Philosophy


by

Lang Chunmei


February 2006

Abstract
Strategic alliances are widely practiced in the automotive, electronics,
computer telecommunications, airlines and hi-technology network-oriented
industries. The airline industry has become one of the most competitive
industries in recent years. The only practical way to secure and increase
market share in international air transport is to align with existing airlines
based in foreign territories. Nowadays, airlines have actively formed strategic
alliances with foreign carriers as a means of forming global networks to
increase passenger and freight market share. Extensive works have been
devoted to studying airline alliances. However, existing studies only focus on
the air passenger alliance and ignore the airline service network structure.
This thesis develops, for the first time, several economic models to study
the strategic alliance of both passenger and cargo services from a network
integration approach. The alliance synergies and network complementary are
addressed.
The thesis is developed in three distinct stages and the results are then
collated and summarized.
The first study addresses the alliance of international service networks of
two regional airlines and develops an alliance model. By examining the
alliance effect on market outcome, profit and social welfare, the decision
analysis tools for both government and airlines are developed.
The second study presents an economic model to examine the effects of
the alliances between the combined passenger and cargo networks and the
dedicated cargo networks. These two service networks have different route
structures where the passenger-cargo network is designed to meet passengers
demands, while the dedicated cargo network is cargo oriented. Three
parameters are introduced: network coverage, flight capacity and shipment
handling quality, to characterize different networks, and alliance synergies are
evaluated by time, service equality and cost saving. The model predicts that
cargo alliance between these two networks will likely increase cargo service
ii
quantities for each network whilst the rival carrier, who owns both two
networks, would lose some cargo services. Furthermore, this carrier also loses
some profits to the cargo alliance partners. Results also show that cargo
network alliances would decrease full prices and increase social welfare.
Sensitivity analysis is performed using simulations to investigate the
relationship between network design and alliance synergies.
The third study introduces a strategic alliance model to evaluate the
competitiveness of forwarders and integrators in the air cargo market. The
rivalry between an integrator and a forwarder-airline alliance is examined by
considering the intermodal integration. It is found that under economies of
traffic density, an improvement in intermodal operations for a forwarder-
airline alliance would increase the alliances outputs and profits whilst
harming the market rivals. For the forwarders, the forwarder-airline alliance
model is more profitable than the outsourced, no-alliance model.
This research studies the economic models for the development of airline
strategic alliances. The unique characteristics of passenger and cargo networks
in different service markets are explored. Strategic alliances for both passenger
and cargo services are analyzed through the passenger network alliance
synergies, cargo network alliance synergies, and the passenger-cargo network
complementary. The research provides a methodology for the airline industry
to analyze the formation of strategic alliances and the selection of strategic
partners in both the passenger and freight markets and in a combination of
both.
iii
Acknowledgements
I am very grateful to Professor Y V Hui, my thesis supervisor. I thank him
for many things. This work would not have been possible without his
continuous support, encouragement and guidance. He has always been
available and welcomed discussion with me at all times. He taught me how to
conduct original research and write research papers, and gave me insightful
suggestions on my research work. He shared with me his knowledge and
experiences, and gave me valuable advice on research and career development.
I would like to express my gratitude to Professors Anming Zhang and
Lawrence C. Leung who also supervised me during the course of my PhD
study. I learned much from them during research meetings and the many
discussions with them have been of great help to my research. They provided
valuable inputs and enriched my dissertation immensely. My PhD life would
have been more difficult without their help. My gratitude also goes to Dr. H P
Lo and Dr. Bruce Lam, who served as panel members for my PhD qualifying
examination.
I would like to thank the Department of Management Sciences of City
University of Hong Kong for giving me the opportunity to pursue a PhD
degree. I am also thankful to the support staff in the Management Sciences
Department for always being helpful.
Last but not least, I would like to thank my parents and family for their
constant love and support.


iv
Table of Contents
Title Page
Abstract
Acknowledgments
Table of Contents
List of Figures
List of Tables
Chapter 1 Introduction 1
1.1 A Brief Review of Airline Alliances 3
1.2 Background to Air Cargo Alliances 7
1.3 Motivations and Thesis Organizations 10

Chapter 2 Literature Review 12
2.1 Managerial Studies on Strategic Alliances 12
2.2 Empirical Studies on the Airline Alliance Effects 15
2.3 Theoretical Models for Airline Alliances 18
2.4 Literatures on Air Cargo Alliances 20

Chapter 3 Decision Analysis for International Air Network
Alliances 23
3.1 The model 24
3.1.1 Basic Assumptions 24
3.1.2 The Pre-Alliance Model 27
3.1.3 The Post-Alliance Model 30
3.2 Impact on Airlines Output and Profit 34
3.3 Impact on Economic Welfare 38
3.4 Decision Analysis 40
v
3.5 Summary 44

Chapter 4 Airline Alliances for Passenger and Cargo Networks

4.1 Introduction 44
4.2 The Model 49
4.3 Effects of the Alliance 57
4.4 Network Design and Alliance Synergies 61
4.4.1 Effects of Network Structure Change 63
4.4.2 Effects of Network Setup Cost Change 67
4.5 Summary 69

Chapter 5 Competition Models in Intermodal Transport
Logistics 70
5.1 Introduction 70
5.2 Basic Model 73
5.3 Effects of Alliance and Intermodal Integration 76
5.4 Effects of Alliance and Competition 81
5.4.1 Simulation Study on Market Share and Profit 85
5.4.2 Simulation Study on Deciding the Discount Rate 88
5.5 Summary 90
Chapter 6 Conclusions 92
References 96
Appendices 104
Appendix A 109
Appendix B 111
vi
List of Figures
3.1 Airline service network 25
3.2 Partners profit change as a function of fixed cost F and traffic density
37
3.3 Social welfare change as a function of fixed cost F and traffic density
39
3.4 Profit and welfare changes as a function of fixed cost F and traffic
density 40
4.1 An example of P/C network route structure 51
4.2 An example of C network route structure 51
4.3 A simple airline service network 52
4.4 Cargo output of firm A, relating to network parameter 64
4.5 Cargo output of partners B+D, relating to network parameter 65
4.6 Cargo output of firm A, relating to marginal cost 66
4.7 Cargo output of partners B+D, relating to marginal cost 66
4.8 Firm As profit change, relating to network parameter 67
4.9 Partner B+Ds profit change, relating to network parameter 68
5.1 A simple cargo transport network 73
5.2 Participation Constraint Function for transportation firms G and N,
relating to discount rate 89
5.3 Forwarder Fs profit change relating to discount rate 89
vii
List of Tables
5.1 Comparison of cargo quantities between the forwarder and the integrator 87
viii
Chapter 1 Introduction
A strategic alliance is considered to be a medium- to long-term
partnership of two or more firms with the goal to improve the partners
competitive advantages collectively vis--vis their competitors by sharing
risks and resources, market-access capability, improving product quality and
customer services, and thereby, improving profitability (Oum, et al. 2000).
This concept is already widely practised as a corporate strategy in the
automobile, electronics, computer, airline, telecommunications, and other
network-based industries.
Strategic alliances can allow companies to create successful products,
rapidly enter new markets and share resources whilst containing risk and costs
in todays competitive business climate, since the individual company usually
cannot develop new strategies and markets without investing time, assuming
great risk, and absorbing extensive costs. Further, strategic alliances can be
helpful to construct complementary service networks, improve product
distribution and optimize marketing strategies. Furthermore, strategic alliances
combined with equity investments would often create more value for the
alliance partners.
A Coopers & Lybrand study reported that 55% of the USs fastest growing
companies were involved in an average of three alliances, and another 8% had
plans to enter an alliance over the next 12 months (The Wall Street Journal,
April 20, 1995, p. A1). In recent years, quite a number of new alliances
between companies have been developed to share the scarce resources and
benefit from partners expertise. Organizations in the U.S. entered into more
than 20,000 new alliances from 1987 to 1992. Most major corporations listed
in the Fortune 500 list are engaged in alliances with other firms and nearly 6
percent of Fortune 1000 companies revenues come from alliances. It is
evident that firms involved in alliances had 11 percent higher revenue and a 20
percent higher growth rate than companies not engaged in any alliance activity
(American Productivity & Quality Centre (APQC), Jan. 1998, P. 71). Alliances
1
obviously have a dramatic impact on an organizations success.
Among all the industry groups, the airline industry has the largest number
of alliances. By 1999 the total number of international alliances had increased
nearly 83% over 1994 up to 513 (Airline Business, July, 2000). The air
transport industry has grown rapidly in the last decade and there is an
increasing focus on the logistics services of both passengers and cargo.
However despite that rapid growth, international air transport has been
essentially governed by a complex system of bilateral air service agreements
(ASAs) between countries.
Consequently, it would be almost impossible for a single airline to satisfy
both passengers traveling with globalized and diversified destinations, and
cargoes moving via intermodal systems within multimodal environments.
Rather than operating independently, most major airlines have aligned with
other airlines based in foreign territories, to form international logistic
networks for both passenger and cargo services, thus providing more efficient
and convenient services to multinational customers.
It is predicted that because of the convenience of global alliance networks,
the increase in traveling public numbers will earn a greater market share for
the carriers as well (Oum, et al., 2000). The three main airline alliances (Star
Alliance, SkyTeam and Oneworld) are predicted to account for 80 percent of
the total world airline capacity (ASKs) by 2005, with 19 of the worlds 20
biggest airlines as members. Events such as September 11, and developments
since, accelerate rather than create trends towards consolidation (Reports from
Tourism Futures International, July 20
th
, 2005).
In this thesis several decision models are developed to examine the
economic effects of strategic airline alliances on firms profits, market share,
consumer surplus and social welfare, with both passenger and cargo services
examined. The study is conducted from a network integration approach and
examines the alliance network rivalry. This chapter develops the background
knowledge of airline alliances and briefly summarizes the research
contributions.
2
1.1 A Brief Review of Airline Alliances
In this section, the history, current status and future development of airline
alliances are examined. The motivations for airlines to form strategic alliances
are also discussed.
After U.S. deregulation 1978, the major U.S. domestic airlines began to
form feeder-carrier networks by code-share alliances. These multi-hub airline
networks provide efficient and high frequency services to thousands of origin-
destination city-pair markets (Oum and Tretheway, 1990). Many other carriers
in Canada and in the European Union realized the necessity to secure the
majority ownership of their regional feeder airlines and they followed the
deregulation of their markets (in 1988 and 1998) respectively. However,
further inter-continental liberalization of the North American and European
markets stimulated airlines to expand and strengthen their international routes,
and intercontinental networks have been developed by the alliances since the
late 1980s. The first international alliance, which is still functioning, was
formed in 1989 between Northwest and KLM Royal Dutch Airlines. Since
then, many international alliances have formed and alliances among airlines
have become an increasingly common feature among the various airlines in
the world.
Over recent years airlines have developed far-reaching marketing
alliances with varying degrees of success. The global alliance networks have
begun to form, and these alliances are an important factor in airline
development with members generating marketing and operational benefits.
The Star Alliance, formed by United, Lufthansa, SAS, Air Canada, Varig
Brazilian, and Thai Airways International was the first initiated in 1997.
Subsequently, other major global alliance groups, such as OneWorld Global
Alliance and Global Wings, followed in 1999. Frequent flyer programs and
integrated route networks are amongst the benefits evident to alliance
customers. Airlines not flying particular routes can offer their customers
extended network benefits through alliances.
3
It is predicted that global alliance networks will become stronger over
time, because most passengers are expected to patronize global network
carriers, and switching alliances will definitely increase the cost for a carrier.
Further, the stronger the market power of global alliance carriers, the more
regulatory reviews of the anticompetitive consequences of the alliances will be
instigated by different national, continental and worldwide institutions. The
largest airline alliance, Star Alliance, now serves over 790 airports in 139
countries, with 19 partners members included, and this will be expanded
16,930 daily flights to 846 destinations in 151 countries as South African
Airways (SAA) and SwissAir join in the next 12 months.
The motivations for airlines to form strategic alliances are diverse and the
most important ones are:
1) An extended and optimized network. This is often realized through
code sharing agreements.
1
Many reasons determine consumers
preference for airlines, such as ease of connections, frequent flyer
incentives, and reduced probability of lost baggage etc. By
connecting the partners service networks, carriers are able to
expand their routes beyond their respective territories and provide
seamless service for their customers.
2) Traffic feed between partners. After the coordination of partners
service networks, each carrier would be able to feed traffic to the
other and thus increase the respective load factor. A key purpose
underlying alliance formation is the exchange of traffic between
networks.
2


1
Code sharing is a business term which first originated in the airline industry. It refers to a
practice where a flight operated by an airline is jointly marketed as a flight for one or more
other airlines. Most if not all major airlines nowadays have code sharing, and code sharing is a
key feature of the major airline alliances. The term "code" refers to the identifier used in flight
schedule, generally the 2-character IATA airline designator code and flight number.
Codesharing agreements allow each airline to provide services with its partners flights, even
though it does not operate its aircraft. Under a code sharing agreement participating airlines
can present a common flight number for connecting flights and flights from both airlines that
fly the same route.

2
Around $500 million of Deltas approximately $16 billion revenue in 2000 was attributable
4
3) Cost reduction. This can be fulfilled by taking advantage of
economies of scale, increased traffic density, and economies of
scope.
3
By sharing of the sales offices, maintenance facilities,
operational facilities (e.g. catering or computer systems),
operational staff (e.g. ground handling personnel), and investments
and purchases (e.g. in order to negotiate extra volume discounts),
alliances will result in economies of scale. Further, both network
expansion and mutual traffic feed bring partners higher traffic
density, which enables increased flight capacity whilst unit costs
can be reduced accordingly. Furthermore, economies of scope can
also be realized by new entrant airlines which may provide efficient
connecting services to the new origin-destination markets.
4) Improved service quality. Measuring service quality is difficult
since it involves customer perception of what it should be. There
are several important dimensions which could be used to depict the
customers judgment about quality travel, such as frequency,
schedule convenience, and ease of on-line connection. A successful
alliance can increase flight capacity, provide more convenient flight
schedules and increase the number of on-line connections, which
would decrease the delay time for the connecting passengers, and
offer more itinerary choices.
5) Further, some marketing advantages such as enlarged FFP
(Frequent Flyer Program), CRS (Computer Reservations System)
display, and the advantages of market share and cooperative pricing
are important reasons to stimulate the alliances.
However, the possibilities for airlines to form alliances are often restricted
by laws and regulations or subjected to approval by authorities. Alleviating the

to alliance flows (Pinkham, 2001).

3
When more units of a good or a service can be produced on a larger scale, yet with (on
average) less input costs, economies of scale (ES) are said to be achieved. Economies of scope
is an economic theory stating that the average total cost of production decreases as a result of
increasing the number of different goods produced.

5
regulatory restrictions on access to foreign markets and the foreign ownership
limitations in most countries seems to be the most important motivator for
alliances.
4
So as long as formal or invisible barriers to entry into foreign
markets exist, airlines will continue to consider forming alliances with other
airlines.
In this thesis two kinds of alliances are considered: complementary and
parallel. The complementary alliance refers to the model where two firms
link their existing networks and build a new complementary network to
provide improved services for connecting passengers. Three major strategic
alliances exemplify this group: British Airways/US Air, KLM/Northwest and
United/Lufthansa. KLM/Northwests hub networks connected 88 U.S. cities to
30 European and Middle Eastern cities by December 1994 (U.S. General
Accounting Office, 1995). The parallel alliance refers to the case where firms,
prior to their alliance, are competitors in some markets of their networks. The
partners integrate non-stop services on some routes where only one partner
continues the services. For example, Delta and Sabena made this type of
alliance on the New York-Brussels route which only Sabena continues to
service.
Due to network complementarities, alliances may earn greater outputs for
partners and the total welfare should improve as a result of complementary
alliances. However, a parallel alliance is likely to decrease total output and
increase full price in a market where the alliance formed, and it is likely to be
helpful to reduce competition not only in the market where the partners
compete with each other before cooperation, but also in other markets of the
alliance network. In general, both the alliances would increase partners profits.
A complementary alliance enables the partners to improve their services and
harm the rival airlines, whilst a parallel alliance enables partners to reduce
operating costs through joint operations.

4
The basic motivation behind alliances is to reap the benefits of consolidation in the absence
of mergers, which are not allowed by most governments (Sinha., 2001, P7.)
6
1.2 Background to Air Cargo Alliances
Like alliances in other industries, an airline alliance is a network with
multiple products where each product is corresponding to passenger or cargo
movements in a particular city-pair market. However, unlike the airline
alliance in the passenger arena, the concept of cargo alliances is comparatively
new and just beginning to spread in the air freight world. In this section the
cargo industry and cargo alliances are reviewed.
Initially, the airline business began by carrying mail, then developed into
the paying-passenger business, and finally moved to the freight business.
Although it has a comparatively short history, the air freight business is the
fastest-growing segment of the airline industry. Between 1980 and 2000, the
volume of international air freight traffic, measured in freight tonne-kilometers,
grew fivefold (ICAO Journal, 2001). The 2004 Boeing World Freight Fleet
Forecast states that the number of freighters in operation will double by 2023,
and the long-term air cargo market will grow at an average rate of 6.4 percent
per annum over the next 20 years a tripling of the market. Although it is a
small business compared to the passenger business, the air cargo service is
very important and even has a higher growth than the passenger market.
Normally, traditional service providers in the air freight industry are
segmented as the following five categories:
Integrated Carriers, or integrators, who combine transport modes in
the air and on the ground to provide a complete door-to-door service
and sophisticated logistics services. Integrators operate internationally
on their own facilities. The 4 major global operators are UPS, FedEx,
DHL and TNT.
Non-Integrated Cargo Carriers, who do not provide a complete
transportation service as do the integrators, provide scheduled
services on major traffic lanes which are used by shippers or
forwarders. They also provide outsourcing, carrying contracted
freight for forwarders and other airlines. Unlike the integrators, they
7
have fewer assets and do not need terminals to sort or process the
freight, nor do they need extensive staffing such as truck drivers. As a
result, they are much smaller than the integrators.
Combination Passenger/Cargo Carriers, who typically form
partnering arrangements with freight forwarders, trucking companies,
postal services and couriers, rely on third-parties to assemble
shipments and then deliver to airport terminals. Combination
passenger/cargo carriers not only provide combination
passenger/cargo service in the same aircraft, but may also provide all-
cargo service, where only cargo is transported in a given aircraft.
Postal Services, which provide overnight mail services, are usually
owned by national governments. The US Postal Services (USPS) is
the largest in the world.
Freight Forwarders, are stand-alone brokers/operators who interface
with shippers and co-ordinate and manage the distribution of freight
worldwide. They do not ordinarily operate airlines; instead they are
wholesale purchasers of airline capacity. They can also provide
ground feeder service, specialized support services such as assistance
in clearing customs, inspections and other logistical support. The
largest freight forwarders operate internationally for pickup and
delivery services, such as Eagle Global Logistics, have contracted for
dedicated air routes, though most of them are on a small scale or
serving in a single location.
Traditionally air cargo freight was mainly operated in a Forwarder-
Airline-Forwarder format, in which airlines provided an airport-to-airport
service and forwarders managed the rest of the transport logistics. The
structure of the global distribution industry has changed radically over the past
decade. With the high growth of air cargo tonnage and the advanced IT
application in logistics, the sophisticated and reliable global distribution
services have been in great demand. As a result, integrators have emerged as
serious competitors and played a very important role in the air cargo industry
8
by offering integrated door-to-door service rather than fragmented individual
services. This kind of challenge has led to some competitive and strategic
responses between the forwarders and the cargo airlines, such as partnership
and collaboration at industry level, consolidation through mergers and logistic
management development. The air freight industry is entering a consolidation
phase with growing horizontal and vertical integration to offer seamless and
global network services.
When considering the airline revenue management, the cargo service
component has to be considered separately, since passenger carriers were
originally drawn together by common passenger-strategic interests to form
alliances. However this does not mean that the common interests will also be
shared by the cargo side automatically. Historically, many cargo operators,
including major airline customers, were skeptical about whether alliances in
the cargo sector would be possible or profitable, because they questioned
whether the viability and benefits of such an option would be worthwhile.
Global transportation has undergone a revolution in technique, methods
and function during the past decade. Moving freight was once rather an
uncomplicated task of transporting shipments from one point to another. Most
major carriers have now joined international networks to gain global reach and
achieve economies of scale so as to better compete with the large integrators
and each other. Aeromexico Cargo, Air France Cargo, Delta Air Logistics and
Korean Air Cargo formed SkyTeam Cargo, the worlds largest cargo airline
alliance, in September 2000. They are partnered to provide shippers with
access to global route network, common service options, sales and service
standards, and an interfaced information technology system that ensures cargo
coordination and delivery throughout SkyTeams global network. WOW
alliance was founded by Lufthansa Cargo, SAS Cargo and Singapore Airlines
Cargo in April 2000 and JAL Cargo joined it in July 2002. The WOW cargo
alliance commands a combined fleet of 43 freighters and the bellyhold
capacity of more than 760 passenger aircraft, and offers an unparalleled route
network of destinations, linking the world's major trading centers.
Shared capacity, resources, manpower and technology bring the partners
9
more direct flights and better access to secondary markets. This also
maximizes shippers global route networks and provides the best possible
service to their customers around the globe. Cargo alliances among major
combination carriers are critically significant and necessary for airlines to
compete in the global air freight arena. Even with their existing partners, both
SkyTeam Cargo and WOW continue to add new members for the new markets.
United Airlines, a member of the Star Passenger Alliance but a stand-alone
operator in the freight world, is looking to become part of a cargo alliance for
its future viability (Airlines Pairing Off, Air Cargo World, Jan. 2004).
Alliances are becoming increasingly prominent and may even begin to obscure
the brands of their individual members.
1.3 Motivations and Thesis Organizations
The importance of airline alliances has attracted much attention in the past
decade. However few sources are devoted to competition between alliance
networks, and the strategic motives of the alliances have not been addressed
theoretically. This study develops the economic models to examine the rivalry
between the alliance networks, where each alliance member maximizes its
own profit and, to a certain extent, its partners profits in the interacted
markets. By investigating the economic effects on output, profit and social
welfare a decision analysis model for alliance partners to share the strategic
advantages is developed and tested.
Compared to airline alliances in the passenger service networks, cargo
alliances are just beginning to spread in the air freight world and there are few
research papers examining this concept. In this thesis the strategic alliances,
including both passenger and cargo services, are tested through analytical
models. The alliance synergies and complementary effects of passenger and
cargo network integration are studied, and by comparing the pre-alliance to the
after-alliance cases tests for airlines to decide whether to join in an alliance
and to what level extent the integration would be developed.
The internet, e-commerce and supply chain management have impacted
10
significantly on the air freight industry. The traditional point-to-point
transportation services have given way to the integrated, reliable and web-
based one-stop logistics services. In the international airfreight markets, it is
common for forwarders cooperating with other service providers to be
competitive with integrators. However, no previous research literature has paid
attention to this issue and this thesis explores the intermodal integration effect
on the competition between an integrator and a forwarder-airline alliance.
Three distinct topics are developed in this thesis. First, an international
alliance model is developed to examine the alliance effects on firms output,
profit and also on the total social welfare. It presents a classical approach
which can be used to investigate the alliance impacts through economic
models. The second economic model examines the synergies of the cargo and
passenger network alliances. It extends the methodology introduced in the first
study to examine the emerging cargo alliance phenomena. The third study
applies the methodology to intermodal transport logistics, and then
investigates the cargo alliance effects, where the competition between different
service providers is investigated.
The thesis is organized as follows: Chapter 2 surveys previous work on
airline alliances. Chapter 3 develops the international alliance model to
examine the alliance effect and decision analysis is given to both the
government and airlines. Chapter 4 studies the synergies of the air cargo
service alliance between the combination passenger-cargo network and
dedicated cargo network, through a theoretical alliance model. Chapter 5
models the competition between intermodal integrated chains. One chain is
the alliance: forwarder, truck firm and airline, and the rival chain is the
integrator. Chapter 6 concludes the thesis and discusses several directions for
future research.

11
Chapter 2 Literature Review
A large number of airline alliances have been formed during the 1990s
and they have been extensively studied in the past decade. In this chapter
previously related work about strategic alliances is reviewed.
2.1 Managerial Studies on Strategic Alliances
A lot of managerial research focuses on the non-strategic motives of
alliances, such as how to choose a good alliance partner, how to manage
alliances successfully, and how to have access to financial and technological
resources, or the detailed techniques and processes of alliance management.
Hamel et al. (1989) introduced some new concepts related to strategy
which are used to revitalize corporate performance. Harrigian (1988)
constructed a framework for using joint ventures within varying competitive
environments. This framework suggests that industry traits, where firms may
wish to form joint ventures, determine the form, focus, duration and autonomy
dimensions of firms cooperative strategies, and competitor traits suggest how
firms will respond to these needs for cooperation.
Hennart (1991) studied firms choices of behavior in determining what
kind of strategies should be more profitable through a large sample empirical
study, and also gave some factors for firms to determine their choices. And
later, Hennart et al. (1997) investigated the determinants of the choice between
two alternative methods of pooling similar and complementary assets: the
merger/acquisition and the greenfields equity joint venture. The results show
that equity joint ventures are preferred over acquisitions when the desired
assets are linked to non-desired assets. Pisano (1990) studied the factors which
affect a firms choice between internal (hierarchical) and contractual (market)
modes for organizing a product R&D program. The paper discovered
transaction costs play an important role in market-versus-buy decisions.
Kogut (1988) developed a few theoretical perspectives on the creation and
12
termination of joint ventures and also summarized three main motivations
behind the formation of strategic alliances: firstly, high transaction costs
resulting from small-number bargaining; secondly, strategic behavior aimed at
enhancing a firms competitive position or market power; and thirdly, a quest
for organizational knowledge or learning when one or both partners desire to
acquire some critical knowledge from the other. Kogut et al. (1988)
investigated whether characteristics of national cultures influence the selection
of entry modes, and the results show that some cultural factors do affect entry
choice. Mody (1993) identified some factors that strengthen an alliance, and
the essential trade-off in the generation and sharing of knowledge versus the
possibility that a partner may act opportunistically.
5

Another important area of management literature discusses the effects of
strategic alliances on partners performance: how strong and stable the alliance
is, the survival status and future directions of the strategic alliance, the stock
returns and perceived satisfaction of managers.
Blodgett (1992) used Event History methodology to examine factors that
may contribute to the instability of joint ventures between U.S. multinationals
and foreign companies. The result showed that joint ventures are more
unstable when partners start out with uneven shares of equity and when the
contracts have been previously renegotiated.
Dussauge and Garrette (1995) presented a study linking the performance
of international joint ventures and airline alliances to their strategic and
organizational features. Economic performances for difference alliance types
were evaluated.
Chan et al. (1997) investigated share price responses to the formation of
some strategic alliances spanning 1983-1992. The results showed that average
stock price response is positive, with no evidence of wealth transfers.

5
Although some of this literature is concerned mainly with joint ventures, to some degree, a
strategic alliance is similar to a joint venture because both can represent a relatively new thrust
by each participant. And most of these contributions about joint ventures do make sense to
strategic alliance management. However there are differences between them, and sometimes
additional attention needs to be paid, especially considering the international management
issues.
13
Partnering firms tend to display better operating performance than their
industry peers over the five-year period. The research showed both parallel
and non-parallel alliances are valuable. Das et al. (1998) studied the impact of
strategic alliances on the firms valuation. By analyzing 119 strategic alliances,
they found that announcements of technological alliances enjoyed greater
abnormal returns in the stock market than marketing alliance announcements.
Alliances are definitely the organizational mode of choice in the current
international aviation environment. However, that environment is facing the
prospect of radical changes (Gudmundsson, 1999), including continued
industry deregulation, advancing open skies and, potentially, expanding
common aviation areas such as the proposed Transatlantic Common Aviation
Area (TCAA). Although it is not so clear if these changes might affect the
trends of alliances formation, it is timely for airlines to pay more attention to
alliance stability and survival. Gudmundsson et al. (2001) tested a proposed
typology predicting survival and duration in airline alliances using data from
the Airline Business annual surveys of airline alliances. Their results showed
that the alliances containing joint purchasing and marketing activities had
lower risk of termination than alliances involving equity. Furthermore,
alliances spanning more than two typologies showed lower risk of termination
than one and two typology alliances.
Oum et al. continues to publish on strategic airline alliances in both
theoretical and management literature. Significantly, in 1997, their paper
described the current status of government policy towards airline alliances,
discussed the effects of intercontinental alliances, and made some predictions
on the future direction of alliance network formation. They concluded that
alliances among airlines were not a passing phenomenon but rather a mature
fixture of the industry, and those alliances among major airlines would be
strengthened in the future. The study also revealed that equity alliances tended
to be unstable, and in the future, there would be fewer alliances with equity
investment. In a survey of 46 airline alliances among major carriers, the paper
pointed out some major areas for coordinated and joint activities. Further, the
major reasons for airlines to form alliances were examined, such as: expansion
14
of seamless service network, traffic feed between partners, cost efficiency,
improved service quality and advantage of CRS (computer reservation system)
display etc. In 2001, they discussed regulatory issues related to international
airline alliances. They predicted that in the near term, alliances would remain a
dominant form of inter-airline relationship in international air transport, and
regulatory structures controlling international alliances should include
convergence of national competition policies and enforcement practices within
the general framework of competition policy.
Recently, Dennis (2005) analyzed the latest developments and attempted
to identify the implications for airline network structures and the function of
different hub airports. He pointed out that during the last two years, some
retrenchment of long-haul services from European airports had occurred due
to the difficult business conditions, yet the four largest airlines have widened
the gap with the others by continuing to expand intercontinental services at
their major hub airports. However hubs remain crucial to maintaining some
competitive advantage over the low-cost new entrants and to feed the long-
haul flights. The main strategic response of the major airlines to changing
industry conditions had been to group themselves into international alliances.
2.2 Empirical Studies on Airline Alliance Effects
There are a number of empirical studies investigating the effects of
international airline alliances on market output, fares and social welfare.
Gellman Research Associations (USDOT, 1994) measured the impact of
codesharing agreements of BA/USAir and KLM/N using data for the first
quarter of 1994, at the request of the U.S. Department of Transportation. They
conducted a counterfactual scenario analysis based on a model using the post-
alliance period only and estimated that the two alliances increased consumer
surplus by $10.3 million and $27.1 million respectively, during the first
quarter of 1994. Based on the interviews with representatives from
governments and airlines, the U.S. General Accounting Office (USGAO, 1995)
concluded that alliances between U.S. and foreign airlines have generated
15
large gains for the participating carriers in terms of passengers and revenues.
Youssef and Hansen (1994) investigated the strategic alliance effects on
service quality, market concentration, and fare levels by producing a case
study on the international alliance between SAS and Swissair. After the
comparison of services pre- and post-alliance, the study showed that both
market share and the average service frequency in the markets, where alliance
partners offered the connecting services, were increased. Further, the alliances
partners could increase market concentration and their own market share in
connecting markets, whereas prior to the alliance these objectives conflicted.
The results also predicted that fares in non-stop markets between alliance
partner hubs had increased more than in other non-stop markets in the same
region, and this kind of increase was a concentration-mediated effect.
Oum et al. (1996) studied the effect of codesharing agreements on the
market leaders price and passenger volume by focusing on trans-Pacific
markets. They presented an estimation of the impacts of a codesharing
agreement between non-leader carriers on the market leaders price and
passenger volume, and showed that a codesharing agreement increased the
annual equilibrium quantity of the market leader by 10,052 passengers while
reducing its equilibrium price by $83 per passenger. Brueckner (1997)
analyzed the effects of international airline codesharing on traffic levels and
welfare using specific demand and cost functions. He showed that the
beneficial effect of codesharing outweighs its harmful effect for most
parameter values in his theoretical model.
Brueckner and Whalen (1998) examined whether alliance partners charge
lower interline fares than non-allied carriers. They found that an alliance
between two previous competitors would raise fares by about 5% in their
gateway markets, but the effect is not statistically significant. Brueckner and
Whalen (2000) provided evidence on the effect of international airline
alliances on fares. The main finding is that alliance partners charge interline
fares that are approximately 25 percent below those charged by non-allied
carriers. They examined this kind of fare reduction in detail using a theoretical
model, and the results showed the reduction was the internalization of a
16
negative externality that arises from the uncoordinated choice of interline
sub-fares in the absence of an alliance.
Brueckner (2003) explored the effect of airline cooperation on the level of
interline fares paid by the international passengers. The analysis focused on
two measures of cooperation, codesharing and antitrust immunity, and the
results showed that the presence of codesharing on an international interline
itinerary reduces the fare by 8%-17%, and the presence of antitrust immunity
reduces the fare by 13%-21%. However, the combined effect (both
codesharing and antitrust immunity considered) ranges between 17%-30%,
which provided strong evidence that airline cooperation in the fare-setting
process generates substantial benefits for interline passengers.
Park and Zhang (2000) investigated alliance effects on air fares, passenger
volume, and consumer surplus based on four major alliances in the North
Atlantic aviation markets. The four airlines: British Airways/USAir,
Delta/Sabena/Swissair, KLM/Northwest, and Lufthansa/United Airlines, were
investigated through a structural estimation of oligopolistic international
airline markets. They found the equilibrium passenger volume increased by
some 36,000 passengers annually and equilibrium air fares decreased by an
average of $41 on the routes served by the allied carriers, and that consumers
were generally better off due to the alliances.
There are quite a number of research papers studying the strategic alliance
impact on business performance from different dimensions, such as new
product development (e.g. Shan et al. 1994), cost reduction (e.g. Hennart,
1991), market entry (e.g. Porter and Fuller, 1986), market share (e.g. Afuah
2000), firm value (e.g. Park and Kim, 1999) etc. In particular, Oum et al.
(2004) examined the strategic alliances effect on firm productivity and
profitability through the evidence from the global airline industry. The panel
data from 22 international airline companies, which formed alliances during
the period 1986-1995, were used for this empirical study. The results revealed
that the horizontal alliances make a significant contribution to productivity
gains, whereas they have no overall significant and positive impact on
profitability. The level of cooperation in horizontal alliances influences the
17
strength of the alliance effect on productivity and profitability.
2.3 Theoretical Models for Airline Alliances
Theoretical work on international airline alliances is relatively rare and
recent.
Brueckner (1997) and Park (1997) theoretically examined the effects of
alliances on firms outputs and profits, air fares and economic welfare by
assuming linear demand and linear marginal cost functions in the analytical
model. Both complementary and parallel alliances were considered and after
solving the model, results showed that a complementary alliance is likely to
increase economic welfare, while the parallel one is likely to decrease it.
Besides, the paper gave some conditions under which an alliance improves
economic welfare: for the complementary (parallel) case, economic welfare
increases (decreases) when the size of the markets is sufficiently large, but
decreases (increases) when the size of the markets is not sufficiently large and
economies of traffic density are high. Given the fixed value of traffic density,
economic welfare gets larger (smaller) as the size of the market demand
increases. Furthermore, all the findings have some important policy
implications: first, when evaluating an alliance from a welfare viewpoint, the
extent of economies of density and the size of market demand should be taken
into account; second, government should be very careful in allowing would-be
parallel alliance partners to have antitrust immunity.
Park and Zhang (1998) investigated whether alliances boost partner
airlines traffic. Both a theoretical model and empirical analysis were
conducted to study the partners traffic changes on alliance routes. The model
found that under the standard oligopolistic conditions, a partners traffic on a
gateway-to-gateway alliance route would increase and the partners profit
would likely increase as well. The panel data from four major alliances,
operating on North Atlantic non-stop routes during the period 1992-1994, was
used to test the model, and results showed the partners have greater traffic
increases on their alliance routes than those on their non-alliance routes, which
18
was consist with the theoretical analysis.
International airline alliances allow airlines to coordinate their operations
to provide seamless service, so that an interline trip on the two carriers feels
like travel on a single airline. Although that kind of alliance may enjoy
antitrust immunity, which will lead to higher fares in the interhub city-pair
markets, interline passengers who travel on two carriers will benefit from the
cooperative pricing, which generates an anticompetitive effect. Brueckner
(2001) analyzed that kind of alliance effect on traffic levels, fares, and welfare,
through the economic alliance model. The results showed that an alliance
would reduce competition in the gateway (or inter-hub) market which was
previously served by the alliance partners, but cooperative pricing of trips by
the partners would increase traffic in the connecting market since portions of a
connecting trip are complements. Welfare analysis showed that both consumer
and total surplus typically rise due to the alliance, which suggested the
positive effects of alliances may outweigh any negative effects.
With the same spirit as Brueckner (1997) and Park (1997), Park et al.
(2001) investigated the airline alliances effect on market outcome though a
theoretical model, but the difference in this model is that both the market
demand and cost were not specified but were treated as general functions. Two
typical types of alliances: complementary and parallel alliances were
examined. The results showed that a complementary alliance is likely to
increase total output whereas a parallel alliance is likely to decrease it. The
model also identified some conditions under which economic welfare would
likely improve. Some managerial implications were identified: partner airlines
generally increase profits, whether they form a complementary alliance or a
parallel alliance; a complementary alliance enables partner airlines to improve
their services and a parallel alliance enables partner airlines to reduce
operating costs through joint operations; formation of an alliance, especially a
complementary alliance, can have adverse effects on non-partner firms traffic.
Research on the airline networks is rather sparse. Brueckner et al. (1991)
examined the effect of competition in airline hub-spoke-networks and for the
first time he linked airfares to the airline network structure. Because of the
19
cost complementarities of hub-spoke-spoke networks, competition in a single
market usually created negative network externalities, which will cause a
reduction in traffic throughout the network. The results showed that
competition in a hub-spoke-network may have harmful effects outside the
market where it occurs. Accordingly it suggested that antitrust policy towards
airlines operating hub-and-spoke networks should be reconsidered.
Oum et al. (1995) analyzed the effects of strategic interaction between
deregulated airlines on their network choice, where both linear systems and
hub-spoke network systems were considered. First, the paper evaluated
whether switching from a linear system to a hub-spoke network would confer
a strategic advantage due to the saving cost and improved service quality.
Second, the paper developed an innovative methodology that can be applied in
the analysis of multi-product oligopolistic competition with network-oriented
firms. Network effect and network externality for the hub-spoke system
were identified and analyzed. By considering the two networks rivalry, the
paper showed that if hubbing lowers total cost (which includes both airline and
inconvenience passenger costs), the pursuit of strategic advantages usually
intensifies the extent of hubbing. Even if hubbing raises total cost, airlines
may still consider hubbing since it is a dominant strategy in an oligopolistic
setting and also useful to deter entry.
2.4 Literatures on Air Cargo Alliances
The existing theoretical researches on air cargo service are also quite
sparse, and there is even less published research about cargo alliances.
Zhang et al. (2002a) provided a general discussion contrasting the
different features between cargo service, passenger service and cargo
liberation. Zhang et al. (2002b) examined the cargo liberation effect by a
multi-market oligopoly model, in which the competition between all-cargo
carriers and mixed passenger/cargo carriers were considered. The results
suggested that the separation of air cargo and passenger rights might be not
that easy in Asia due to the characteristics of its air cargo market, where most
20
passenger carriers have a substantial cargo business and operate combi fleets.
It was the first paper to consider the cargo liberation problem in a theoretical
framework.
Zhang (2003) introduced a general conceptual framework for the air cargo
industry and especially Hong Kong air cargo. The interaction between Hong
Kong air cargo and China, and other Asia-Pacific regions and their
international aviation policies was also discussed.
There are few published papers studying the impact of a passenger
alliance on cargo service.
Morrell et al. (1999) identified and quantified the impact of a major
passenger airline alliance between KLM and Northwest Airlines on the
development of cargo service characteristics for KLM. Using the same
methodology of origin-to-destination city-pair matching based on the approach
of Youssef and Hansen (1994), the results showed that the number of possible
city-pair markets available to passengers and cargo shippers increased during
the first three years of the alliance, and the number of non-stop exclusively-
served spokes increased significantly. Further, the connecting services
increased significantly for all the samples and cargo layover times worsened
during the first years of alliance, but subsequently significantly declining
cargo layover times were identified.
Zhang et al. (2004) investigated the effect of cargo alliance on
competition in passenger markets through an oligopoly model. In that case, the
partners form alliances in the cargo markets and still offer their individual
passenger services. The results showed that alliances in the cargo market will
likely increase the partners own outputs, while simultaneously decreasing its
rivals outputs in both cargo market and the secondary passenger market. The
alliance will likely earn some profits for the partners, whilst reducing the
profit of each non-alliance firm. Furthermore, passengers in at least one route
segment will be better off following the alliance, and will be better off in all
markets in the symmetric case. If, assuming homogenous products and
symmetric firms, then total social surplus increases following the alliance.
21
In the above literature review, it was found that the theoretical works on
airline alliances are few, with even fewer papers focused on the cargo alliance
service. The literature did not review the strategic alliance problems from a
network approach. So, motivated by the paucity of information, this thesis
introduces both passenger and cargo services into the alliance models and
analyzes the problem from the service network level, where the network
synergies, network complementarities and the rivalry between networks are
addressed.
22
Chapter 3 Decision Analysis for
International Air Network Alliances
Over recent years airlines have developed various levels of successful
alliances. These alliances are an important factor in airline development for
members to generate marketing and operational benefits. Frequent flyer
programs
6
and hub-and-spoke networks, which developed following
deregulation, are among the benefits evident to alliance customers. Through
this type of arrangement an airline can offer their customers extended network
benefits without adding new services.
7

In a recent passenger survey conducted by Skytax, Star Alliance was
named the worlds best airline alliance (News Release from FRANKFURT,
June 15
th
, 2005). One strategic advantage of Star Alliance is that customer
benefits are delivered under the most comprehensive network of any airline
alliance. Star Alliance expects to expand its network to 846 destinations in 151
countries and to be the leading global airline alliance for the high-value
international traveler in the future. At the same time, other two major airline
alliances, SkyTeam and Oneworld, are also expanding their service networks
to cover more airlines based in foreign territories. Nowadays, membership of
an international airline alliance is becoming a strategic necessity for airlines to
survive.
There is some research that evaluates the international alliance effect both
empirically and theoretically. Brueckner (2001), in particular, considered that
the loss of competition in the inter-hub market will generate a countervailing

6
Through alliances, passengers can accrue frequent flyer miles on their home carriers plans
even though they fly via the partners flight, and also use FFP rewards on any partners flight,
which is more convenient for passengers to accumulate mileage. Besides, since the combined
route network can offer more destinations, the mileage value is increased for passengers.
7
Codesharing agreements can achieve this, through a marketing agreement for two airline
partners whereby one partners designator code is shown on another partners airline timetable.
Codesharing agreements allow each airline to provide service with its partners flights, even if
it has no operation in this route.

23
effect, tending to raise fares in that market. However, welfare analysis
suggests that the positive effects of alliances may outweigh any negative
impacts. Park et al. (2001) predicted that in the international market, a
complementary alliance is likely to increase total output while a parallel
alliance is likely to decrease it. This chapter first develops the pre-alliance
model as a benchmark, and then investigates the post-alliance case. Both the
competitiveness of strategic alliance networks and the alliances impact on
market outcome and economic welfare will be examined. Finally, some
decision analysis will be developed for government and airlines. The point of
difference in this thesis when compared with the existing literature is that both
complementary and parallel alliances are considered in the model. In addition
to the alliance partners, competitors for each market are also introduced, and
the decision analysis, based on the alliance effect for each carrier and
government, is developed.
3.1 The Model
3.1.1 Basic Assumptions
Consider an air transport model given in Figure 3.1. It consists of two
domestic markets (Market 1 and Market 2) and one international market
(gateway-to-gateway market, Market 3). There are five different airlines: A, B,
C, D, and E, included in the model. Through gateway (hub) cities b, airline A
operates routes to the domestic market 1, noted as service network A
1
, as well
as routes to international market 2, noted as service network A
2
. City c is a hub
served for airline B to operate both international service network B
2
and
domestic service B
3
. C
1
, D
2
and E
3
are service networks for airlines C, D and
E respectively, which are introduced to denote the competitors for both airlines
A and B in the related market.
24
A
2
, B
2

A
1
B
3
c a b d
C
1

E
3

D
2

International Domestic Domestic
Market 1 Market 2 Market 3

Figure 3.1. Airline service networks.

The network structure in Figure 3.1 presents two domestic city-pair routes:
ab and cd, and one international route bc (interhub route). If each airline
operates separately, connecting passengers have to transit at hub cities b or c
for different airlines, which is very inconvenient. However, if airlines A and B
form complementary alliance by coordinating services A
1
with B
2
, B
3
with A
2
,
then new international itineraries ac and bd could be provided, which benefit
the interline passengers (their travel needs both carriers) with decreased transit
time and better air fares (Brueckner, 2001). Further, in Market 2, A and B are
competitors in serving interhub route bc, but if they form a parallel alliance by
coordinating services A
2
and

B
2
, then this would benefit the interline passenger
traveling on route ad.
An example for this network can be: a corresponds to Hangzhou, a
medium city in China providing only domestic air flights, b to Shanghai, a
gateway city with two international airports, c to Paris and d to Barcelona.
Airline A may be corresponded to China International Airline and B to Air
France, C, D and E to some local airlines, for example: C corresponds to
Shanghai Airlines, D to China East Airlines, and E to Iberia Airlines. Since
there are no direct flights between Hangzhou, and Paris (Barcelona),
international passengers traveling across the medium cities in China, e.g.
Hangzhou, to some cities in Europe, e.g. Paris or Barcelona, have to travel
with both China International Airline and Air France (Iberia). Further, after the
alliance between airlines A and B, (China International Airline and Air France),
through the gateway cities b and c, (Shanghai and Paris), passengers in both
China and Europe can have more city-pair itinerary choices. Since 2002,
China International Airline has worked with Air France in a codesharing
25
agreement in the Shanghai Paris itinerary.
This model examines the economic effect on each airlines market share
(passenger numbers), profit, air ticket price, and even social welfare, after the
alliance between A and B in both the domestic market and international
markets. The inverse demand function for Market i is given by , where
is the total round-trip traffic carried by service network j in this market.
Note that Q gives the traffic in both directions by service carrier j. For
example, equals the number of passengers traveling from a to b and back
plus the number of passengers traveling from b to a and back via service
carrier A
) (
j i
Q P
j
Q
j
1
A
Q
1
.
Each airline has to realize the fare arbitrage when they set the fares in
different markets. We assume at this point that the fare for the interline
passenger paid to the alliance partner would be less than the one for him to
choose two different non-allied airlines. For example,
bc ab ac
+ , where
ac
denotes the fare for passenger flying from city a to city c. It is obvious
since if
ac bc ab
> + , then a passenger wanting to fly from city a to city c
would rather fly less expensively by purchasing two different round trip
tickets, than by purchasing an alliance partners ticket. In this way the alliance
need not be considered at all. Similarly, it is necessary to set this fare
assumption to the interline passengers in route b-c-d.
A common cost function C gives the total operating cost for carrying
T passengers in the route, where T denotes the routes traffic density. This cost
function reflects economies of traffic density
) (T
8
, with C satisfying
and . A fixed setup cost, denoted by , is assumed for
each service network.
( ) T
( ) 0
'
> T C ( ) 0
' '
< T C F

8
If the marginal cost of an additional passenger is decreasing in T (C<0), then we say that
the airlines technology exhibits economies of traffic density, which implies that the cost per
passenger, C/T, is also decreasing in T.
26
3.1.2 The Pre-Alliance Model
In the absence of an alliance, each company works individually to
maximize its own profit. But it should be noted that airlines A and B can
provide both domestic and international services, and the interaction between
these two services for each company should be reflected in the model. Then
1

( 0 1
1
) is used to measure the integration between A
2
and A
1
, and
2
A 1
Q
represents the number of additional passengers in Market 1 initiated from
Market 2 traveling by carrier A. This group of passengers needs international
service, traveling through more than one market (interline passengers).
Similarly,
2
and
2
2 B
Q describe the case for B
2
and B
3
in airline B.
Given the assumption, each airlines pre-alliance profit function can be
expressed as:
) ( ) (
) ( ) )( (
2 2 2 2 2
2 1 2 1 1 2 1
2 2
1 1 1 1 1
b
A
b
A
b
D
b
B
b
A
b
A
b
A
b
A
b
A
b
C
b
A
b
A
b
A
Q C Q Q Q Q P
Q Q C Q Q Q Q Q P
+ + +
+ + + + =
(3.1)
) ( ) (
) ( ) ( ) (
2 2 2 2 2
2 3 2 3 3 2 3
2 2
2 3 2 2 3
b
B
b
B
b
D
b
B
b
A
b
B
b
B
b
B
b
B
b
E
b
B
b
B
b
B
Q C Q Q Q Q P
Q Q C Q Q Q Q Q P
+ + +
+ + + + =
(3.2)
) ( ) (
1 1 1 2 1
1 1 1
b
C
b
C
b
C
b
A
b
A
b
C
Q C Q Q Q Q P + + = (3.3)
) ( ) (
2 2 2 2 2
2 2
b
D
b
D
b
D
b
B
b
A
b
D
Q C Q Q Q Q P + + = (3.4)
) ( ) (
3 3 3 2 3
3 2 3
b
E
b
E
b
E
b
B
b
B
b
E
Q C Q Q Q Q P + + = (3.5)
where superscript b stands for before-alliance. We consider the equilibrium
that arises where these five airlines play a Cournot game in each market of the
network. Each airline will choose its optimal output to maximize its own profit,
given the output decisions of its rivals.
Given the above assumptions, the profit-maximization problem is written
as:
(3.6)
b
E
Q
b
D
Q
b
C
Q
b
B
Q Q
b
A
Q Q
b
E
b
D
b
C
b
B
b
B
b
A
b
A
Max Max Max Max Max
3 2
1
3 , 2
2 , 1
, , , ,
27
The primary goal is to compare the post-alliance solution to the pre-alliance
solution, which is given by eqn (3.6), in order to examine the alliances impact
on market outcomes and economic welfare. Unfortunately, it is intractable to
do the comparison since the solution is very complicated, unless more
structure is imposed on the model. Following Brueckner and Spiller (1991)
and Brueckner et al. (1992), we assume that both demand and marginal cost
functions are linear:
0 , ) ( > =
i i i
Q Q P (3.7)
0 , 1 ) (
'
> =
i i i
T T C . 3 , 2 , 1 = i (3.8)
where
i
represents the level of demand (scale of demand relative to costs)
for each market and
i
measures the extent of increasing returns to traffic
density (constant returns corresponds to 0 =
i
)
9
. Note that both the intercept
of marginal cost and the slope of marginal revenue are simplified to one.
We consider the equilibrium that arises where these five airlines play a
Cournot game in each market of the network. Each airline will choose its
optimal output to maximize its own profit, given the output decisions of its
rivals. The pre-alliance first-order conditions for Airline A can be written as
follows:
( )
b
A
b
A
b
C
b
A
b
A
Q Q Q Q Q
2 1 1 2 1
1 1 1 1
1 2 2 + = (3.9)
( )
( ) ( )
b
A
b
A
b
A
b
D
b
B
b
A
b
C
b
A
b
A
Q Q Q
Q Q Q Q Q Q
2 2 1
2 2 2 1 2 1
2 1 1 1
2 1 1 1
1 1
2 2 2


+ + =
+
(3.10)
Similarly, the first-order conditions for other airlines can be expressed as
follows:

( )
b
B
b
B
b
E
b
B
b
B
Q Q Q Q Q
2 3 3 2 3
2 3 2 3
1 2 2 + =
(3.11)

9
Brueckner et al. (1992) and Brueckner and Spiller (1994) have established that economics of
traffic density are significant in the airline industry. Since the model solutions are too
complicated to be compared, linear assumptions of market demand and marginal cost
functions are very useful in empirical studies.
28

( )
( ) ( )
b
B
b
B
b
B
b
D
b
B
b
A
b
E
b
B
b
B
Q Q Q
Q Q Q Q Q Q
2 2 3
2 2 2 3 2 3
2 2 3 2
2 2 3 2
1 1
2 2 2


+ + =
+
(3.12)
(3.13)
b
C
b
A
b
A
b
C
Q Q Q Q
1 2 1 1
1 1 1
1 2 =
(3.14)
b
D
b
B
b
A
b
D
Q Q Q Q
2 2 2 2
2 2
1 2 =
(3.15)
b
E
b
B
b
B
b
E
Q Q Q Q
3 2 3 3
3 2 3
1 2 =
The left side of each equation from (3.9) to (3.15) denotes the marginal
revenue for every service network in each market, and is set to equal to the
marginal cost of serving one passenger in that market, which is shown in the
right side of each equation. It should be noted that C , which means the
marginal cost will be decreased as the served passenger quantity increases.
0 (.)
' '
<
Solving equations (3.9)-(3.15) gives the following solutions for (3.6):

2
2 1
1
1
4
) 1 (
3
1
1

=
b
A
Q (3.16)

2
2
4
1
2 2 2

= = =
b
D
b
B
b
A
Q Q Q (3.17)

1
1
3
1
1

=
b
C
Q (3.18)

2
2 2
3
3
4
) 1 (
3
1
3

=
b
B
Q (3.19)

3
3
3
1
3

=
b
E
Q (3.20)
It can be shown that the second-order conditions for model (3.6) reduce to:
. 3 , 2 , 1 , 2 = < i
i
(3.21)
Besides, outputs and marginal costs need to be positive, and
i
is constrained
so that
29

( )
( )
3 3 2 2
2
3
2 2 1 1 2 1
2
1
3 1
4
3
1
4 1 , 3 1
4
3
1

< <

+
< < < <

+
(3.22)
With the present demand and cost specifications, the profit for each airline in
pre-alliance case is:
F
b
A
2
) 4 ( 2
) 2 ( ) 1 (
) 3 ( 2
) 2 ( ) 1 (
2
2
2
2
2
2
1
1
2
1

(3.23)
F
b
B
2
) 4 ( 2
) 2 ( ) 1 (
) 3 ( 2
) 2 ( ) 1 (
2
2
2
2
2
2
3
3
2
3

(3.24)
F
b
C

=
2
1
1
2
1
) 3 ( 2
) 2 ( ) 1 (

(3.25)
F
b
D

=
2
2
2
2
2
) 4 ( 2
) 2 ( ) 1 (

(3.26)
F
b
E

=
2
3
3
2
3
) 3 ( 2
) 2 ( ) 1 (

(3.27)
3.1.3 The Post-Alliance Model
As discussed previously, airlines A and B are possibly motivated to
cooperate with each other by integrating their domestic services and
international services for better connecting services. For example, company B
may coordinate with airline As domestic service network A
1
to provide better
connecting services for the international passengers. This is part of the
complementary alliance. However, in the international market, company A and
B still have motivations to be partners by integrating the service networks A
2

and B
2
. This is the parallel alliance, since before the alliance they were
competitors in this market.
The complementary alliance is likely to increase output as well as profit
for the partners, whilst it would harm the rival carriers by decreasing their
outputs and profits. Collaboration between the partners seems likely to provide
30
better service but at lower prices for the connecting services. Accordingly, the
alliance partners would own more market share by attracting some new
connecting passengers and by attracting some passengers from the rival
companies with their improved services. The partners can feed more
connecting traffic to each other compared to the rival non-allied airlines, so
they can further increase load factors on their O-D routes and the respective
operating costs on these routes will be reduced. That is why they can offer the
lower air fares to O-D passengers. On the other hand, the parallel alliance,
which essentially decreases the degree of the competition in the market, is
likely to decrease total output and increase full price in a market where the
alliance is formed. Consequently, the consumer welfare is likely to decrease in
that market. But if considering both complementary and parallel alliances at
the same time, the economic effect of the alliances would be complicated and
this research just focuses on this problem.
Thus, we develop a model of the simple parallel alliance case in which A
2

and B
2
are merged into one network, denoted by (A+B,2), to provide services
in the international market. They also offer the domestic services A
1
and B
3
in
Markets 1 and 3 respectively. Airlines A and B were competitors before, but
now they are partners in the international market and in order to offer a higher
quality connecting service, the partners (A+B,2) would coordinate arrival and
departure flight schedules, locate departure gates for connecting flights near
arrival gates, and coordinate baggage transfer and other similar activities in
this interhub market. Here we assume that the partners agree to equally share
revenues and costs arising from the joint service in the international market.
The partnership (A+B,2) increases their competitive capability against
Airline D in the international market. It also introduces an integrated service
that moves passengers from one domestic market to another through the
partnership international service. We use Q to denote the total passenger
numbers served by the partners (A+B,2) in international Market 2 and
denotes the number of passengers traveling from Market 2 to
Market 1 through carrier A. Similarly, describes the connecting
a
B A 2 , +
B A
Q
2 +

a
B A
Q
2 , 1 +

a
2 ,
31
passengers travel from Market 2 to Market 3 by airline B.
The post-alliance profit function for each airline can be expressed as:


(3.28)
) ( ) )( (
) ( ) (
) ( ) )( (
2 , 2 3 2 , 2 2 , 2 3
2 , 2 , 2 , 2 , 2 ,
2 , 1 1 2 , 1 2 , 1 1
3 3 3 3
2
1 1 1 1
a
B A
a
B
a
B A
a
B
a
E
a
B A
a
B
a
B A B A
a
B A
a
D
a
B A B A
a
B A
a
A
a
B A
a
A
a
C
a
B A
a
A
a
B A
Q Q C Q Q Q Q Q P
Q C Q Q Q P
Q Q C Q Q Q Q Q P
+ + +
+ + + + +
+ + + +
+ + + + +
+ +
+ + + + =


(3.29) ) ( ) (
1 1 1 1
1 2 , 1 1
a
C
a
C
a
C
a
B A
a
A
a
C
Q C Q Q Q Q P + + =
+

) ( ) (
2 2 2
2 , 2 , 2 ,
a
D B A
a
D
a
D
a
B A B A
a
D
Q C Q Q Q P
+ + +
+ = (3.30)
a
E
a
E
a
E
a
B A
a
B
a
E
Q C Q Q Q Q P
3 3 3 3
3 2 , 2 3
) ( + + =
+
(3.31)
where superscript a stands for after-alliance, and P respectively
denote the inverse demand function and cost function in Market 2 under post-
alliance case.
2 , 2 ,
,
B A B A
C
+ +
The profit-maximization problem for post-alliance case would be written
as:
(3.32)
a
E
Q
a
D
Q
a
C
Q
a
B A
Q Q Q
a
E
a
D
a
C
a
B
a
B A
a
A
Max Max Max Max
3 2 1 3 2 , 1
, , ,
2 ,
,
+
+
Given eqns (3.7) and (3.8), the first-order conditions for each firm can be
written as follows:
( ) ( )
a
B A
a
A
a
C
a
B A
a
A
Q Q Q Q Q
+ +
+ = +
1 1 1 1
1 1 1
1 2 (3.33)
( ) ( )
( ) ( )
( ) ( ) ( ) ( )
a
B A
a
B
a
B A
a
B A
a
A
a
E
a
B A
a
B
a
D
a
B A
a
C
a
B A
a
A
Q Q Q Q Q
Q Q Q
Q Q Q Q Q
2 , 2 3 2 2 , 2 2 , 1 1 1
2 , 2 3 2
2 , 2 2 , 1 1 1
3 1
3 3
2 1 1
1 1 1
2
2 2
+ + +
+
+ +
+ + + + =
+ +
+ +




(3.34)
( ) ( )
a
B A
a
B
a
E
a
B A
a
B
Q Q Q Q Q
2 , 2 3 2 , 2 3
3 3 3
1 2
+ +
+ = + (3.35)
a
C
a
B A
a
A
a
C
Q Q Q Q
1 1 1
1 2 , 1 1
1 2 =
+
(3.36)
32
a
D
a
B A
a
D
Q Q Q
2 2
2 2 , 2
1 2 =
+
(3.37)
a
E
a
B A
a
B
a
E
Q Q Q Q
3 3 3
3 2 , 2 3
1 2 =
+
(3.38)
Solving eqns (3.33)-(3.38) yields the following solutions:

2
2
1
1
1
3
1
3
1
1

=
a
A
Q (3.39)

2
2
2 ,
3
1
2

= =
+
a
D
a
B A
Q Q (3.40)

2
2
2
3
3
3
1
3
1
3

=
a
B
Q (3.41)

3
3
1
1
3
1
,
3
1
3 1

=
a
E
a
C
Q Q (3.42)
It can be shown that the second-order conditions for each firms profit
maximization problem reduce to
2 , 2
3 1
< < , and ( )
3
2
2 1
2
1 2
2 , 2 min < . (3.43)
Since outputs and marginal costs should be positive, the demand level is
constrained such that
( )
1 1 2 1
2
1
3 1
3
3
1

< <

+ (3.44)

2 2
3 1 < < (3.45)
( )
3 3 2 2
2
3
3 1
3
3
1

< <

+ . (3.46)
With the present demand and cost specifications, using eqns (3.39)-(3.42)
the profits for each firm after the alliance is formed are as follows:
F
a
B A
3
) 3 ( 2
) 2 ( ) 1 (
) 3 ( 2
) 2 ( ) 1 (
) 3 ( 2
) 2 ( ) 1 (
2
3
3
2
3
2
2
2
2
2
2
1
1
2
1

=
+

(3.47)
33

F
a
C

=
2
1
1
2
1
) 3 ( 2
) 2 ( ) 1 (

(3.48)
F
a
D

=
2
2
2
2
2
) 3 ( 2
) 2 ( ) 1 (

(3.49)
F
a
E

=
2
3
3
2
3
) 3 ( 2
) 2 ( ) 1 (

(3.50)
3.2 Impact on Airlines Output and Profit
In order to examine the alliance effects on output and profit, it is
necessary to compare the pre-alliance solutions with the post-alliance
solutions.
Using eqns (3.16)-(3.20), (3.39)-(3.42), we can calculate the output
changes for each firm as follows:
( ) ( )
( )( )
2 2
2
2
2 1
2
2 1
4 3
1
3
1
4
1
1 1 1

= =
b
A
a
A A
Q Q Q (3.51)
( )(
( )(
)
)
2 2
2 2
2
2
2
2
2 ,
4 3
2 1
4
1
2
3
1
2 2

=
=
+ +
b
B
b
A
a
B A B A
Q Q Q Q
(3.52)
( ) ( )
( )( )
2 2
2
2
2 2
2
2 2
4 3
1
3
1
4
1
3 3 3

= =
b
B
a
B B
Q Q Q (3.53)
( )( )
2 2
2
2
2
2
2
4 3
1
4
1
3
1
2 2 2

= =
b
D
a
D D
Q Q Q (3.54)
0
3 1
= =
E C
Q Q (3.55)
Here, for the convenience of comparison we assume that the integration
level between the international market and domestic market is the same no
matter whether or not the alliance is formed, that is
1 1
= and
2 2
= .
Proposition 3.1. After merging, (1) the joint firm will produce more output
than that of either firm before merging, however the output amount is less than
34
the sum of all partners outputs before merging. (2) For the joint partners
competitor in same market, it will produce more output due to the rivals
merging. (3) The output quantities remain unchanged for airlines C and E in
two domestic markets.
Proof. Using eqns (3.17) and (3.40), we can have

( )( )
2 2
2
2
2
2
2
2 , 2 ,
4 3
1
4
1
3
1
2 2

=
=
+ +
b
B
a
B A
b
A
a
B A
Q Q Q Q
(3.56)
For the feasible range of
2
and
2
, the signs for the equations (3.54) and (3.56)
are definitely positive but negative for equation (3.52). So we can get

2
(3.57)
0 ,
,
3 1 2 2
2 2 2
2 ,
= = >
+ < <
+
E C
b
D
a
D
b
B
b
A
a
B A
b
B
b
A
Q Q Q Q
Q Q Q Q Q
The following result will show focus on the output change for each market
rather than firm, which is denoted by
i
Q , . 3 , 2 , 1 = i
Proposition 3.2. The Alliance has no effect on the total output for each
domestic market, but the international market is different and the change
depends on the extent of traffic density
2
. In detail, the total market output in
international market would be (1) increased when 1
2
> ; (2) keeps unchanged
when 1
2
= ; (3) reduced when 1
2
<
10
.
Proof. Using eqns (3.16)-(3.20) and (3.39)-(3.42), we can get
(3.58) 0
1 1 1 1
1
= + =
b
C
b
A
a
C
a
A
Q Q Q Q Q
(3.59) 0

3 3 3 3
3
= + =
a
E
a
B
a
E
a
B
Q Q Q Q Q

10
Several different papers (Caves et al. 1984, Brueckner et al. 1992 and Brueckner and
Spiller 1994) posited that the economies of traffic density are significant in the airline industry.
Consequently, we will examine the economic effects of alliance by considering the variable
ranges of increasing return to traffic density, which is denoted by parameter .
35

( )( )
( )( )
2 2
2 2
2 , 2
4 3
1 1
2 2 2 2




=
+ =
+
b
D
a
D
b
B
b
A
a
B A
Q Q Q Q Q Q
(3.60)
It can be easily shown that 0
2
> Q when 1
2
> ; 0
2
= Q when 1
2
= ;
when 0
2
< Q 1
2
< . Of course, here
2
should be confined to the feasible
range as what (3.44)-(3.46) demand. Q.E.D.
Although the merger will not bring a positive output change for
international markets all the time, it cannot be said that it reduces its profit,
since the profit is affected by both the output and the air fares. Next we will
focus on the profit change for each firm and the joint partners.
Proposition 3.3. After merging, (1) no profit change for each domestic
market; (2) no profit change to airlines C and E in domestic markets; (3)
Partners competitor in international market, firm D, is definitely profitable;
(4) the partners will be profitable, when 2 2
2
, so it is with the total
profit change for international market; but when 2 2
2
< , the profit
change for the joint partners is related to fixed cost F and the detailed
relationship is given by following Figure 3.2.
It should be noted that the profit change of the international market is also
the amount for all three markets, because the output changes for the two
domestic markets are all zero.
Proof. Referring to eqns (3.1)-(3.5) and (3.47)-(3.50), we get the profit
change for each firm:

( )
F
b
B
b
A
a
B A B A
+


= =
+ +
2
2
2
2
2
2 2
2
2
) 4 ( 3 2
) 2 4 ( ) 1 (


(3.61)

( )
( )
2
2
2
2
2 2
2
2
) 4 ( 3 2
2 7 ) 2 ( ) 1 (





= =
b
D
a
D D
(3.62)
0 = =
E C
(3.63)
Within the feasible ranges of
2
and
2
limited by inequalities (3.22) and
36
(3.44)-(3.46), when 2 2
2
> , the sign for eqn (3.61) is definitely positive;
when 2 2
2
= , it would be equal to zero; when 2 2
2
< , it will be
decided by the amount of F . However for eqn (3.62), it can be easily shown
that its sign is definitely positive. Q.E.D.
F
2
3 2

0 <
2
)
2

As discussed above, in some cases, it is not possible to develop a definite

solution for the profit change of the partners and the total international market.
Referring to eqn (3.61), we can get a function for fixed cost with respect to
parameter
2
such that

( )
2
2
2
2
2
2 2
2
) 4 (
) 2 4 ( ) 1 (




= F (3.64)
It can be plotted as the following figure
11
:


2 2
2
=
2

0.2 0.4 0.6 0.8 1

Figure3.2. Partners profit change as a function of fixed cost F and
traffic density .

Obviously,
+B A
in region , where 2 2
2
<
and
( )
2
2
2 2
3 2
) ) 1 (

< F
2
2
2
2
4 (
4 (

. That means the joint partners profit will be

decreased after the merger. Similarly, in region , where 2 2
2
<

11
For the simplicity, the following figure is given by fixed the demand level = 2, and so do
the next 2 figures.
37
but
( )
2
2
2
2
2
2 2
2
2
) 4 ( 3 2
) 2 4 ( ) 1 (




> F , we can get 0 >
+B A
, in a sense that the
joint partners profit will be increased due to the merger. As to region ,
where 2 2
2
> , the joint partners profit will be increased. It seems that
only for regions and , where the two partners A and B are profitable,
would be of interest to airlines to consider for alliances.
The results demonstrate the alliance effect on each carriers output (fare)
in each market, with the assumption that carriers A and B produce
homogenous products in the international market. If the products are
differentiated, economic theory predicts that the fare for the trip from city a to
d is cheaper when A aligns with B than when they operate at arms length.
Accordingly, the traffic will be increased, and this traffic gain compensates the
lower fare, so that both carriers earn higher profit. Therefore, in addition to
benefiting from the schedule coordination and other alliance synergies,
interline passengers (traveling from a to c, through the three markets) enjoy
lower fares following the alliance. However in the international market
(gateway-to-gateway market), the fare will rise.
3.3 Impact on Economic Welfare
When examining the alliances impact on economic welfare by comparing
the total welfare pre-alliance to that post-alliance, there is a net change in total
welfare that can be calculated by adding the net change in consumer surplus to
the net change in the profits of all five airlines in the market.
From the results in the last section, it can be seen that the consumer
surplus remains unchanged in the two domestic markets, and the profits in
these two markets are also unchanged. Then it remains only to focus on the
international market to examine the total economic welfare change. However,
given that the total profit change in the international market is definitely
positive for the feasible range of
2
and
2
, then the total profit change in all
three markets will be positive. That is, when calculating the total social
38
welfare changes, we only need to be aware that the change of consumer
surplus in the international market will be showed by the following result:
Proposition 3.4. After the merger, consumers would be better off, when
1
2
> ; consumer surplus remains unchanged when 1
2
= ; consumers are
worse off when 1
2
< .
Proof. Using eqns (3.7), (3.17) and (3.40), we can calculate the consumer
surplus in market 2 as:
( ) ( ) ( )
( ) ( )(
( ) ( )
)
2
2
2
2
2 2
2
2
'
2 2 2
3 4 2
1 5 17 1
2
2
2
2
2 2 2




= = =
+ + =

dP P Q P Q dQ Q P
CS CS CS CS
a
b
a
b
P
P
Q
Q
D B A

(3.65)
where and represent the price functions before alliance and after
alliance case in market 2 respectively. It is obvious that when
b
2

a
2

1
2
> , the sign
of eqn (3.65) is definitely positive for the feasible range, while when 1
2
= , it
is equal to zero, and when 1
2
< it is negative. Q.E.D.
Then for some cases under which the consumers are worse off, we need
examine the social welfare from a governments point of view. The total
economic welfare change can be calculated as follows:

( ) ( )
( ) ( )
F CS W +

+
= + =
2
2
2
2
2
2
2
2
2
3 4 2
5 15 4 1


(3.66)
We also can illustrate the relation of F and as:
39
2 2 2

8
145 15
2

=

F

0.8
0.2

Figure 3.3. Social welfare change as a function of fixed cost F and
traffic density density .

Then it is obvious for the following result:
Proposition 3.5. After the alliance, for the feasible ranges of
2
and
2
:
(1) when
8
145 15
2

> , the total economic welfare will increase; (2)
when
8
145 15
2

< 0 < , if
2
2
2
2
2
2
2
2
2
) 3 ( ) 4 ( 2
) 5 15 4 ( ) 1 (



+
< F , the total
economic welfare will decrease, but if
2
2

2
2
2
2
2
2
2
) 3 ( ) 4 ( 2
) 5 15 4 ( ) 1 (



+
> F , the
total economic welfare will increase.
It seems that regions and are both of interest to the government,
where the total economic welfares are all increased due to the merging. But it
should be noted that in those cases, the partners may lose profit which means
they may not have the motivation to consider the alliance at all. The following
section will have more details.
3.4. Decision Analysis
In order to obtain a clearer picture of the impact of the alliance on
economic welfare and firms profit as well, Figures 3.2 and 3.3 are combined
in Figure 3.4.
40

1
F
F
2 2
2
=
2

2
F
6
85 11
2

=
8
145 15
2

=




0.2 0.3 0.5 0.6 0.7

Figure 3.4. Profit and welfare changes as a function of fixed cost F and
traffic density .
Note that in Figure 3.4,
2
2
2
2
2
2 2
2
2
1
) 4 ( ) 3 ( 2
) 2 4 ( ) 1 (




= F is for profit change
function and
2
2
2
2
2
2
2
2
2
2
) 4 ( ) 3 ( 2
) 5 15 4 ( ) 1 (



+
= F is for welfare change function.
The following results on economic welfare and airline profitability are
obtained by examining this figure:
(1) When 2 2
2
> , both the economic welfare change and
partners profit change
0 > W
0 >
+B A
, then the alliance benefits both society as a
whole and the merged airlines. If
2
is large enough, such as when 1 >
2
,
consumers are also better off.
(2) When 2 2
8
145 15
2
< <

, 0 > W . The government may force

two airlines to form an alliance. If the network setup costs F ,
then
F <
1
0 >
+B A
. This benefits both society and the two airlines. But if ,
the two airlines may not benefit from the alliance.
F F >
1
(3) When
8
145 15
6
85 11
2

< <

and F F <
1
, both and 0 > W
0 >
+B A
. The alliance will benefit both society and the airlines. If
1 2
F F F < < , then 0 > W and 0 <
+B A
. The government may force the
41
airlines to form an e will be unprofitable to them. If
F F >
2
, then both 0
alliance but the allianc
< W and 0 <
+B A
. An alliance would benefit neither
it will n nsidered. the airlines nor socie
hen
ty, and ot be co
(4) W
85 11
and F F <
2
allia iety an
governm
allia
betw
3.5. Sum
inte
6
2
< 0 > W and 0 >
+B A

nce would h soc d the a If F then

0 < W and 0 >
+B A
benefit bot irlines.
2 1
F F < < ,
. The airlines may prefer to make a ut the
ent would be reluctant due to the negative impact on economic
welfare. If
1
F F < , then both 0
n alliance b
< W and 0 <
+B A
. An alliance would seem
to be a poor option for both the government and the airlines.
Although this model considers both the complement
, both . An
ary and parallel
table after the alliance
mary
In this chapter, an analytic model is developed to evaluate the
nces where the economic effects are examined by the simulation results,
there are some useful public policy implications for the government and
practical suggestions to the airline companies. For example, if we consider the
market demand information and traffic density, which is depicted by
parameters and respectively, then we could get F
1
and F
2
according to the
above formulae. By comparing the fixed cost F with these two numbers, the
airlines would know which conditions are beneficial for them to form alliances
and which are detrimental. Besides, these different situations also tell the
government agencies how to facilitate the positive social welfare effect and
deter the negative aspects of an international alliance.
Also note that company D is absolutely profi
een A and B is formed. This would motivate other airlines to enter the
international market to provide the similar service networks as company D
does.
rnational alliance effects. In the model, the partners merge their
international service networks and then integrate with their domestic service
42
networks to offer services for international passengers. The economic effects
on the firms output, profit, consumer surplus and social welfare are studied
assuming linear demand and marginal cost functions. In the simulation, two
parameters, market demand level and traffic density need to be estimated.
Since most airlines keep good records of traffic flow and market share, these
parameters could be estimated accordingly. In practice, an activity-based cost
approach is widely used to estimate airline operating cost (Gaier et al. 1999
and Tsai et al. 2004). The direct operating cost components include fuel, flight
personnel compensation, flight personnel training, airframe maintenance,
insurance-loss/damage and other operating expenses.
The model results show that the partners output is larger than that of each
individual firm before alliance, but is less than the sum of all merged firms
outputs. Competitors of the aligned partners in the international market will
earn more market share and be profitable. The output and profit for each non-
partner competitor remains unchanged even when there are integrations
between the domestic service networks and the merged service networks in the
international market. The economic welfare effect is examined and detailed
conditions under which the consumer is better off and welfare improved is
discussed. Some model-based decision-making rules are given to both airlines
and the government.

43
Chapter 4 Airline Alliances for
Passenger and Cargo Networks
The air cargo industry has flourished due to the rapid development of e-
business and e-logistics, and shippers are demanding more reliable, accessible,
and quality services from air transport providers. Airlines are
redefining/redesigning their networks by offering global and integrated air
cargo services to their customers. This chapter investigates whether there are
economic motivations for combination carriers to develop the dedicated air
cargo service networks
12
, and what kind of synergies would occur if the
combined passenger-cargo network aligned with the dedicated cargo network.
In reality, these two networks have different route structures since the former
is designed to meet passengers demands, while the latter is cargo oriented. In
the proposed model, three parameters are introduced - network coverage,
flight capacity and shipment handling quality - to characterize network
services. Alliance synergies between these two networks are evaluated based
on time, service equality and cost saving perspectives. By comparing the pre-
alliance model with the post-alliance model, the alliance effect on each cargo
service providers output, profit and the total social welfare is examined.
4.1 Introduction
The air cargo industry has seen significant growth in recent decades.
Sophisticated supply chain solutions have created larger market players and
also forced service providers to review their strategic plans for the future. Air
cargo services become more strategy orientated when taking into account the
demands of high-tech products such as electronics, pharmaceuticals and other

12
The air cargo industry includes three types of carriers: integrated carriers (integrator),
passenger carriers (or combination carriers, they carry cargo in the belly space of the
passenger aircraft), and all-cargo carriers (dedicated cargo carriers).

44
advanced equipment, which have a significantly higher usage of air cargo
service than general commodities. Accordingly, cargo service providers are
motivated to offer better quality global services. The air cargo alliance is one
of the vital strategies for airlines to keep their market positions, manage traffic
and access new markets.
Among the cargo service providers, combination (passenger-cargo)
carriers play a special role in the context of this research. These airline firms
primarily provide point-to-point passenger service, and air cargo service is
traditionally regarded as secondary. On the cargo side, they rely on freight
forwarders in sales and logistics services. Combination carriers move
passengers and general air cargo from one city to another by making use of
their acquired hub-and-spoke network and alliance networks, as opposed to
integrators who have their own airline and intermodal transport networks.
Airfreight transport, through a combination airline network, normally needs
longer time-frames compared to an integrators network. Many combination
carriers are developing and maintaining dedicated cargo networks, trying to
reduce the gap between the integrators on time-definite services.
13

In the passenger airline market, a major trend has emerged where airlines
seek to establish strategic alliances or other forms of co-operation. At present,
four major airline alliances dominate the passenger transport market. Star
Alliance, One World, Sky Team and KLM/Northwest had a total market share
of 61% of IATA members scheduled international passenger kilometers in
2003 (IATA World Air Transport Statistics 2004, p.69). To date these alliance
groups have not really included cargo operations among the members with the
exception of Sky Team. Many researchers concluded that alliances in the air
cargo sector have not produced dynamic customer solutions and far-reaching
synergies for the carriers involved, although without doubt we will see more
enhanced alliance business models in the future. Passenger alliances offer
greater opportunities for the collaboration in cargo services, but it is

13
Many large Asian and European combination carriers, including Korean Air, Cathy Pacific
Airways, Lufthansa, and Air France, operate fleets of freighter aircraft to supplement their
belly cargo capacity (Wells A. and Wensveen J., 2004).
45
inappropriate to apply the same passenger strategies and models to cargo
alliances.
Despite this, passenger carriers are still motivated to align their passenger-
cargo combination networks with dedicated cargo carriers networks. Air cargo
and passenger travel in very different ways:
1) Air cargo can be carried in the belly compartment of a passenger
aircraft; in a dedicated cargo (all-freight) carrier; and in a Combi
aircraft which flies with passengers in the front section of the
aircraft and cargo in the back.
2) Air cargo normally is uni-directional, moved from manufacturing
to distribution centers or from production or distribution to
consumption centers. However passengers usually travel in a
round-trip by flying to the destination and back again.
3) Cargo generally travels with late night departures but passengers
travel with daytime departures; cargo transportation is passive
without special demands on the circumstances, while passengers
walk about the airport, thereby preferring a better environment for
rest or entertainment during their waiting time, and also having
expectations of the cabin conditions.
14

4) Passengers prefer the shorter-elapsed journey times and seamless
service in connecting routes, which leads passenger airlines to
establish multiple hub systems. In contrast, detours are not a
problem for cargo transport; as long as the shipment arrives on
time, the customer does not care how it is routed.
Another difference between cargo and passenger hubbing is the impact of
airport congestion. Grove and OKelly (1986) pointed out that it is impractical
for one passenger airline to monopolize landings for a long period of the day

14
Combination carriers carry air cargo in the passenger flight, which means air cargo flies
during the day as well. This is in contrast to the integrators operations. They are able to fly
express package and documents within their hub-and-spoke networks during night-time,
which would ensure that the product is delivered the next day.
46
(about 2 hours) to fully take advantage of hubbing. The obvious way to escape
congestion is to locate the hub in a small city, which is uneconomical for
passenger airlines because they need large numbers of locally originating
passengers (Toh and Higgns, 1985). However, air cargo carriers normally fly
in the middle of the night and they do not depend on locally originating traffic.
Consequently, each express package company has its hub in a different,
usually small city where there are very few other flights competing for night-
time runway access. As a result of these differences, dedicated cargo carriers
and passenger carriers normally have different routing needs and optimal
network strategies (Kuby and Gray, 1993; Chestler 1985).
Secondly, network products and network designs are different, and the
increase of dedicated air cargo operators prompted combination airlines to
consider developing or maintaining dedicated air cargo networks. A majority
of airlines transport cargo via the passenger carriers, and therefore do not
separate passenger and cargo networks. However, passenger requirements
have higher priority over the cargo, and revenue from the passenger
component of flight revenue is dominant.
15
Scheduling and capacity conflicts
may arise between passenger demands and cargo demands. Compared to the
combination airlines, all cargo airlines are more flexible in designing network
and scheduling routes. With the growth in supply chain management and
shipment security, the separation of cargo and passenger provide airport
operators a greater chance to attract more flexible all-cargo operations.
Therefore freight-only networks are growing fast. In the United States,
dedicated air cargo operators have merged and raised their share of the total
cargo carried from 4% to 60% over the last twenty years.
16
Since then, the
combination carriers are motivated to develop their own dedicated cargo
networks or cooperate with all-cargo carriers.

15
A survey by Airline Business in 1999 shows that passenger revenue accounts for over 70%
of the total for most large airlines in Asia-pacific region.
16
This is because of the rapid development of integrator market in the air cargo industry.
Integrator market was created in the United States during the beginning of the 70s when
FedEx and UPS challenged the traditional cargo and combination carriers. Their market share
was only 3.2% in 1975, however now integrators have gained a market share of total domestic
transportation by air of almost 65% in the US.
47
Thirdly, synergy effects on the network integration and cargo transport
coordination urge cargo carriers to explore alliance opportunities. An
important marketing benefit of the integration of air cargo networks is higher
inter-hub frequencies and a wider range of departure choices, for connecting
origins between one hub to destinations beyond the other, will be supported. A
synchronized network will carry higher cargo volumes. Network expansion,
network design and scheduling decisions will affect the availability of
economies of scope and traffic densities, which will provide the cost saving
for the service providers. By offering alternative routings and more connection
opportunities, the integrated networks will provide improved services. Further,
forwarders can benefit by aligning to a single network with a single rather than
multiple point of contact. With respect to cargo security issues, cargo delivery
is handled by aligned partners rather than by several unrelated service
providers and this is critical with valuable cargo or long haul international
cargo. Information sharing among various carriers will enable the cargo
control to be more convenient (for example, customers can track and trace
their cargo on an alliance platform).
Many airline strategists argue that the major business in the airline
industry is actually network management, and that operating aircraft is
secondary to that effort. (Air cargo world, Jan. 2004) The essence of network
management for many large airlines is to extend the network and expand the
schedule, which means added output with as few incremental capacity costs as
possible. The biggest advantage for the alliance is that network and cargo
alliance partners expect to benefit most from the traffic feed and market access.
With the alliance formed, improved customer service will be across larger
seamless networks and the competition should be considered at the network
level rather than the level of individual O&D markets (Holloway S., 2003).
Accordingly in this research, we analyze the cargo alliance from a network
approach and examine the economic effect of the alliance on each partners
output, profit and the total social welfare.
Morrell and Pilon (1999) studied the impact of a major passenger alliance,
between KLM and Northwest Airlines, on the cargo service characteristics of
48
one of the partners. Gudmundsson et al. (2002) investigated the effect of
multilateral alliances on complex sub-networks such as distribution networks,
cargo alliances and frequent flyer programs. Zhang et al. (2004) developed a
theoretical model and examined the effects on competition in passenger
markets of air cargo alliances by two passenger carriers. This study
investigates the effects on competition of cargo network alliances between
combination passenger-cargo and dedicated cargo networks in both passenger
and cargo markets.
The remainder of the chapter is organized as follows: section 4.2 sets up
the basic airline alliance model and discusses the synergy effects of air cargo
alliances and the incentives for cargo carriers to form alliances. Section 4.3
examines the economic effect of alliances on output, profit and social welfare.
Section 4.4 focuses on the relation between network design and synergy
effects, and section 4.5 gives the concluding remarks.
4.2 The Model
This study considers two types of air cargo networks: one is passenger-
cargo combined (P/C) network where cargo travels on passenger flight, and
the other is the dedicated cargo (C) network where cargo is transported on all-
cargo aircraft. Accordingly, two different kinds of carriers, passenger carrier
and all-cargo carrier, are involved. As discussed in the above section, there are
different characteristics and route structures between P/C and C networks,
since the P/C network is mainly focused on the passenger market, and its route
scheduling is designed to satisfy passengers demands, while C network is
scheduled on a cargo basis. Even within each network, after a forecast level of
demand in a targeted market is given, an airline will have to make decisions
on whether to serve it with a nonstop, multi-stop, online connecting, interline
connecting or code-shared product. Whether the service is offered on a high
frequency, with perhaps a higher unit cost with the smaller aircraft, or on a low
frequency, possibly a lower unit cost with the larger aircraft, is also a
necessary consideration for airline.
49
Corresponding to this we introduce the following two parameters:
network coverage and flight capacity to describe the network
characteristics. They not only show the geographic features of the network,
but are also useful in the measurement of the network service quality.
17
It is
assumed that P/C and C network should have different and . Further, we
introduce shipment handling quality to measure the service quality during
cargo delivery process, relating to the physical states of cargo and carriers
delivery capability but not the network structure. For example, the transit time
for the shipment, cargo loss (damage) experienced and the effectiveness of
tracking and tracing etc, are all the items concerned by .
18

In practice, shippers concern with a variety of issues. A traditional
definition of service quality in cargo logistics is based on the so-called seven
Rs to delivery the right amount of the right product at the right place at the
right time in the right condition at the right place with the right information
(Coyle et al., 1996). The 2003 Air Cargo Quality Survey conducted by
International Logistics Quality Institute, showed what service levels were
provided and expected in intercontinental air freight. Security and customs
regulations rank as the top concerns of intercontinental air shippers, followed
by fuel prices, terrorism, airline financial health etc.
Note that measurements of the three network parameters will not be
addressed where detailed operational issues are not of interested in this study.
It is assumed that the network is fixed and these three parameters depend on
traffic quantities.
The following Figures 4.1 and 4.2 give a simple illustration of the
different features between P/C and C network, where a, b, c, and d are hub

17
Flight capacity describes the network capacity and flight frequency.
18
An in-depth survey of more than 800 shippers who use intercontinental air freight services,
conducted by International Logistics Quality Institute in 2003, presents the notion that service
reliability (43 percent) and rates (32 percent) are the most important attributes for shippers in
choosing freight forwarders, with transit time third at 11 percent. More than 70% of shippers
indicate that a delay of only one or two days in receiving anticipated shipments does not cause
significant problems for them. This also discloses that the importance of service reliability to
shippers comes through loud and clear, and companies are continuing to seek to tighten their
global supply chains and arranging to get product delivered on time, as scheduled, is a critical
function performed by forwarders (Air Cargo World, Dec. 2004).
50
cities and others are destination cities. Since passengers prefer nonstop and
direct routings, we may assume that P/C network has more routes and more
frequent flights compared to C network. Compared to C network, we assume
that the marginal cost for the cargo operations in P/C network is higher, due to
the smaller capacity/traffic tonnage of the cargo carried in the passenger
carrier (not including the cost for the ground transportation component).

y x
a b
d
c
z s
Figure 4.1. An example of P/C network route structure.


y
a
b
t
d c
Figure 4.2. An example of C network route structure.

It is noticeable that these two different types of networks have different
route structures and different flight schedules in the same routes. As discussed
in the above section about the motivations for them to form alliances, it is
expected that the positive synergies will occur in terms of newly created cargo
service routes (network expansion), more convenient flight schedules and
transit times, and cost savings. This will be investigated by the following
theoretical model.
51
As depicted in Figure 4.3, three different airlines A, B and D are included
in the analysis. They are all network carriers: firm A operates both passenger
aircraft and all-cargo aircraft, that is, besides passenger service, it can deliver
cargo with either P/C network or C network; firm B is a passenger carrier
offering both passenger and cargo services but its cargo service is only
provided by P/C network (carrying cargo in the passenger aircraft); firm D is a
all-cargo carrier and its cargo service is offered by C network. Firms B and D
may serve different cargo markets, and normally firm A should have wider
network coverage by serving more cargo markets, but we assume that firm B
(D) competes with for the P/C (C) cargo services in the same cargo markets.
Besides, firm A and firm B compete with each other in the same passenger
markets. We will examine what kind of synergy effect will be shared by the
partners if firm B and D form an alliance, in other words, what the incentives
are for them to consider forming an alliance with each other rather than
operating alone.


Firm B
P/C

Firm A

Firm D P/C & C
C
Figure 4.3. A simple airline service network.

Cargo service is the primary consideration and passenger service is
secondary in the model. We let Q and denote firm is cargo quantity
served by passenger carrier (P/C network) and dedicated cargo carrier (C
network) respectively, and Q denotes the passenger service quantity for firm
i (i= A,B,D) . The demands for firms A, B and D are:
i
1
i
Q
* 1
i
2
52
, and Q (4.1) ) , , (
* 1 2 1
A A A A
Q Q Q Q ) , (
2 1
B B B
Q Q Q
D D
Q
* 1

For simplicity, we introduce the following notation to denote the demand

quantity:
(4.2) ) , , , , , ( ) , , , , , (
6 5 4 3 2 1
1
2 1
1
2 1
* *
q q q q q q Q Q Q Q Q Q Q
D B B A A A
=
Since we are interested in the alliance effect from the cargo side, we will
assume that the service quality of passenger service will not affect the synergy
effect of the cargo alliance. Accordingly the passenger quantity served by each
firm is assumed to be affected by the air ticket price only, denoted byT and
A
B
T .
19
However, the demands of the air cargo service quantity are assumed to
depend upon air freight tariff P and network features: network coverage ,
flight capacity , and shipment handling quality . The cargo demand
functions for each company may be written as:
i i

(4.3)
) , , (
) , , (
) , , (
* 1
6
1
4
* 1 1
3 1
D B A D D
D B A B B
D B A A A A
D Q q
D Q q
D Q Q q q



=
=
= + +
where is the full price of delivering cargo with firm As service network,
is the full price of delivering cargo with carrier B, and is the full
price of delivering cargo with firm D.
A

20
Note that the cargo demand for each
firm depends on all the full prices . For example, Q , cargo
quantity served by firm B, depends not only on , the full price of moving
cargo with firm Bs service network, but also on and , the full prices of
carrying cargo with firm A and Ds service networks. This is because some
connecting cargo services have to be delivered through more than one market,
which may belong to both P/C and C networks.
D B A
, ,

B
1
B
A D

19
Since carrier D only offers cargo service, we only consider carriers B and A for passenger
demand.
20
It should be noted that although in firm As network, cargo services are carried in passenger
carrier and dedicated carrier, the customer may only care about whether the freight can be
delivered on time but not about which kind of network or carrier is used, so we assume there
is only one air freight tariff for both P/C and C network of firm A.
53
The full price is taken to be the sum of freight tariff and the non-ticket
cost of delivery cargo borne by customers, and it can be expressed as:
, ) , (
i i i i i i
g P + + = , 0

i
i
g

, 0

i
i
g

. , , D B A i = (4.4)
Equation (4.4) assumes, as is common in the literature, that consumers are
able to place a dollar value on non-price service attributes. De Vany (1974)
and Panzar (1979) used this kind of non-ticket cost to analyze passengers
travel behavior. We borrow the same idea to address the shippers behavior in
the cargo market. Here measures the shipment handling quality of firm i
from shippers view. g denotes the delayed cost, the value of inconvenience
caused by delivering cargo which is not delivered to the destination at the
desired time as the customers expected.
i

i
21
It is assumed that a decreasing
function of network coverage and flight capacity, because of either wider
network coverage or more frequent flights, will decrease the inconvenience
delay cost. On the other hand, the network coverage for each firms service
network and flight capacity depends on the cargo volume served in this
network. We assume
0 , 0 , 0 ), ( ), ( >

>

<

= = =
i
i
i
i
i
i
i i i i i i i i
Q Q Q
Q Q

),
i
(Q .
(4.5)
This assumption shows that with the network structure fixed, the service
quality will be improved if carrying fewer cargo services, whilst the network
coverage and flight capacity will be improved if cargo quantities increased.
Solving the demand functions for in equation (4.3), we obtain the
following inverse demand functions
i

for i= A, B, D. (4.6) )

, , , (
4 3 2 1
q q q q d
i i
=

21
Sometimes, this can be used to measure the inconvenience cost for customers, owing to the
perishable cargoes or valuable cargoes which are not delivered satisfactorily or with some
damage sustained during the delivery process.

54
Let ( C
i
and C be firm is operational cost of delivering cargo by
the passenger carrier and dedicated cargo carrier respectively; C be the
operation cost for carrying passengers; and be the network setup
cost which depends on the network structure and the shipment handling
quality.
)
1
Q
) ,
i i

) (
* 1
Q
i
) (
2
Q
i
) , , (
i i i i
h
22
Besides, for firm A, there would be some international cargo
services which need transit with both P/C and C networks and this may add
some extra cost. For example, these cargoes need to be transferred by ground
transportation or need to be kept in warehouses for a subsequent flight. This
kind of network integration and coordination cost is assumed to be included in
. Given the assumed demand and cost specifications, the profit
functions for each company can be expressed as:
, (
i i
h


| |
) , , ( ) ( ) ( ) (
). , ( ) .( ) , ( ) , , , (
3
2
2
* 1
1
1
2 5 2 3 1 6 4 3 1
A A A A A A A
A A A A A A A
h q C q C q C
q q q T q q g q q q q d



+ + =

(4.7)

| |
) , , ( ) ( ) (
). , ( . ) , ( ) , , , (
5
2
4
1
5 5 2 4 6 4 3 1
B B B B B B
B B B B B B B
h q C q C
q q q T q g q q q q d



+ =

(4.8)


| |
) , , (
) ( . ) , ( ) , , , (
6
* 1
6 6 4 3 1
D D D D
D D D D D D D
h
q C q g q q q q d

=
.
(4.9)
As discussed in the above section, the cargo services can be coordinated
between P/C and C networks for firm A, or between firms B and D.
Consequently, we assume they are complements for the carrier pairs:

22
Normally, for a combination passenger-cargo service network, the setup cost comprises both
passenger and cargo components and we may need to introduce different cost functions h
accordingly. (For example, passenger cost function has no relationship with shipment handling
quality , but this parameter is important to the cargo cost.) However, in the model, the
alliance effect is considered from a whole network view but not distinguished from different
service markets, and for simplicity, only one cost function h is introduced for each network.
55
, (4.10) 0
0
0
0
, 0
4 6
> >
D B
d d
while the passenger services between carriers A and B are substitutes:
(4.11) 0 , 0
2 5
< <
D A
T T
where subscripts j,( j=1,,6) denote partial derivatives with respect to outputs
. Moreover, the cargo outputs between P/C network and C network satisfy
the following network complementarities property:
j
q
. (4.12) , 0 , 0
64 46 13
> > >
D B A
This implies that for firm A (or firm pairs B and D), a higher cargo quantity in
P/C (C) network will increase the marginal profits on the C (P/C) network.
The passenger services for firm A and firm B are strategic substitutes:
. (4.13) , 0
52 25
< <
B A
The cargo outputs of the rival firms (i.e. firm A vs. firms B and D) are
substitutes:
. (4.14) 0 , 0 , 0 , 0 , 0 , 0
3 1 3 1 6 4
< < < < < <
D D B B A A
d d d d d d
Following the standard practice in oligopolistic competition with quantity
as strategy variable (Dixit, 1986 and Tirole, 1988), we assume that the outputs
of the rival firms in the same competitive market are strategic substitutes, that
is
; (4.15) , 0 , 0 , 0
63 41 36 14
< < < <
D B A A
and in the different markets,
. (4.16) 0 , 0 , 0 , 0
61 43 34 16
< < < <
D B A A
Although both cargo and passenger are carried on the passenger-cargo
carrier, we assume the passenger demand would not be affected by the cargo
alliance. Therefore,
56
0 , 0
5 4 45 2 1 12
=


=

q q q q
B
B
A
A
.
23
(4.17)
Similarly, this is the same for passenger service and cargo service carried by
the dedicated cargo carriers:
0 , 0 , 0
5 6
65
6 5
56
3 2
23
=


=


=

q q q q q q
D
D
B
B
A
A
. (4.18)
4.3 Effects of Alliance
After firm B aligned its P/C network with firm Ds C network, we will
consider carriers competition between firm A and partners B and D in the
Cournot fashion and the equilibrium exists when each firm or alliance partners
choose its cargo output to maximize profit. The optimal solution is given by:
MAX


) , , ; (
A A A A A A
Q
Q
A
=
, ; (
B B B D B
Q
Q MAX
B
= +
, ; (
D D D B D
Q
Q MAX
D
= +
) , , ; ( ) ,
D D D D D B B
Q +
, , ; ( ) ,
B B B B B D D
Q + )
(4.19)
where denotes firm is profit, and the extent of the alliance is measured by
i
, 0 1 .
24


23
There are varying arguments about this assumption. Fox example, it is assumed that there
are joint economies in the service process of the passenger-cargo carrier and accordingly the
left side of this equation will be positive (Zhang and Zhang , 2002b). There, the paper
discussed the effect of cargo liberation on both passenger and cargo, and the positive condition
ensures an increase of cargo output will reduce the marginal cost of passenger output, and vice
versa. However, here in this model, what we are more concerned with is the synergy effect
from the cargo service network alliance, and we pay less attention to the effect on the
passenger side, therefore it is reasonable to assume the economies of scope away.
24
It should be noted that, in the passenger-cargo carrier, the cargo service quantity should be
constrained by the passengers service quantity, since the flight is designed for passengers
demand first. For example, normally this constraint can be issued as the ratio of cargo quantity
to passenger quantity equal to some constant number, specified in advance according to the
carrier structure or empirical data. Then if considering this, this model will be changed to a
Lagrangian problem, which would need a more complicated solution. Accordingly, for the
sake of simplicity, we neglect this kind of constraint, but the following analytical results will
not be affected by this assumption.
57
The pre-alliance case is related to 0 = , while 1 = corresponds to the full
alliance (merger) case. Here, we need to compare the case of 1 = with 0 =
to examine the changes of quantity and profit in each firm. However, it is very
difficult to compare this directly, even in some special cases. Then we treat
as a continuous variable between 0 and 1 and assume Q is differentiable in
this range. The overall output change owing to the alliance effect can be
expressed as
) (
i
(4.20) d d dQ Q Q Q
i i i i
] / ) ( [ ) 0 ( ) 1 (
1
0

= =
Oum et al. (1995) and Park J. et al. (2001) used similar techniques in the
analysis of airline hubbing effects and complementary alliance effects
respectively. Our concern would be on the infinitesimal effect
since the overall alliance effect would be reflected by its sign.
d dQ
i
/ ) ( ,
The first order conditions for problem (4.19) are:

B
(4.21)
0
0 , 0
0 , 0 , 0
6 6
5 5 4 4
3 2 1
= +
= + = +
= = =
B D
D B D
A A A

The second order conditions are assumed to be satisfied and the equilibrium is
stable. Note that the stability condition is important and if the equilibrium is
unstable, then a slight deviation by one player may cause deviations for other
players far from the equilibrium and this would make the equilibrium
untenable. Then the equilibrium will be unreachable and hence unobservable
in practice. The stability of the Cournt-Nash equilibrium was studied by Seade
(1980), Dixit (1986), Slade (1994), and Zhang and Zhang (1996).
Proposition 4.1. After the alliance between firm Bs passenger-cargo
network and firm Ds dedicated cargo network, firm A produces less cargo
outputs in both P/C and C networks, while the partners B+D produce greater
cargo outputs in both networks. The passenger output remains unchanged for
both firm A and partners B+D.
The proof for proposition 4.1 and other propositions of this section are
58
given in Appendix A. Intuitively there are network complementarities
discussed in (4.12) between P/C network and C network. However, before
alliance, this kind of effect of firm Bs output on firm Ds profit is not
significant, because they only focus on maximizing its own profit. After the
alliance is formed, the partners would cooperate to maximize the joint profit
by coordinating the schedules, expanding the routes structure, and perhaps
offering more frequent flights, which will bring in positive synergy effects.
That is, the alliance partners will increase their respective quantities to make
full use of the complementarities, whilst rival A would reduce its output since
their products are substitutes in the same competing cargo markets. On the
other hand, since the passenger service has higher priority over the cargo
service in the passenger-cargo network, the network is designed for passengers
first, and the cargo output change would not have an effect on the passenger
numbers. That is why the passenger outputs for both firm A and firm B remain
unchanged.
The alliance influences the output for each carrier in the cargo market,
with firm A losing cargo service quantities to the alliance partners B+D.
However it does not mean the profit change goes the same way, since profit is
decided by both outputs and air fares. The following result shows that the
alliance does help the partners earn more profits from the rivalry.
Proposition 4.2. After the alliance between P/C and C network, firm A
earns less profit whilst the alliance partners B+D earn more.
This result further shows that the alliance partners can damage the original
firm As cargo services. Alliances between passenger-cargo networks and
cargo networks do help the partners gain strategic advantages in market-share
rivalry and in profitability.
Referring to Proposition 4.1, it is still not clear whether the total cargo
output change in either P/C network or C network is due to the alliance, since
firm A decreases output in each network, whilst the partners increase their
outputs. The following results explain the total output change and full price
change for the P/C and C network respectively. The total welfare is also
59
studied.
Proposition 4.3. After the alliance between firms B and D, total cargo
output will be increased and accordingly the full price of the cargo services
for either P/C network or C network will be decreased. In the particular case
where the cargo demand is symmetric between P/C network and C network
and carriers B and D have the same cost function, the alliance will cause
increased total cargo output and decreased full prices on both networks.
Consequently, shippers would be better off.
Finally, we consider the impact of the alliance on economic social welfare,
which is the sum of consumer surplus and firm profits. To examine the effect
on total welfare, we consider a partial equilibrium framework in which
consumer demand for cargo in each network is derived from a utility function
which can be approximated by the form
U (4.22) Z q q q q q q + ) , , , , , (
6 5 4 3 2 1
where Z is expenditure on a competitively supplied numeraire good, and

D
D
B B
B
A A
A
q
U
Q
U
T
q
U
q
U
Q
U
T
q
U
q
U
q
U
Q
U

6
5 4
2 3 1
) , ( ) , (
) , ( ) , (
(4.23)
Then the consumer surplus in this framework can be written as
. (4.24)
] ) ( [
) , , , , , (
5 2 6 4 3 1
6 5 4 3 2 1
q T q T q q q q
q q q q q q U CS
B A D B A
+ + + + +
=

Total surplus is then
W , (4.25) ) (
D B A
CS + + + =
Substituting (4.7)-(4.9) into (4.25) gives
60
| |
| |
D B A D B B A A A
D D B B A A
h h h C C C C C C
q g q g q q g
q q q q q q U W
+ + + + +
+ + + + + +
=
* 1 2 1 2 * 1 1
4 3 2 1
6 5 4 3 2 1
) ( ) ( ) )( (
) , , , , , (
(4.26)
Proposition 4.4. For the symmetric case, total welfare rises as a result of
the alliance between P/C and C network.
To sum up the alliance effects: the partners total cargo output is likely to
be increased, whilst the cargo output of the rival, non-partner firm would
decrease (by Proposition 4.1) in both P/C network and C network; this effect
in market-share rivalry translates to the profit gain: the alliance would earn
greater profit for the partners while the non-partner earns less profit (by
Proposition 4.2); the full prices of the cargo services in whole P/C network
or C network would decrease and increase the social welfare.
4.4 Network Design and Alliance Synergies
In the previous section, we examined the effect of the alliance between
network carriers B and D on the cargo output, firms profit and total social
welfare. The analytical results predict that positive synergies in terms of
additional cargo outputs and profits would motivate the passenger-cargo
network carrier to be aligned with the dedicated cargo network carrier.
However it should be noted that all these results are derived with the
assumption that network structure is fixed. In this section we examine the
economic effect of network redesign on each service providers market share
and profit, with the alliance formed.
Airline service network design in general addresses two fundamental
questions: which markets should we be adding or deleting; and what would be
the implications of adding or deleting specific routes or channeling O&D
markets in a different way? (Holloway S., 2003) Here we assume that the
cargo service network design issue would be addressed by changing network
61
coverage , flight capacity , and also the shipment handling quality .
25

We consider a simple alliance case where network carriers B and D
merged to maximize the joint profit together rather than individual profit,
while the strategy for firm A is unchanged.
26
Referring to equations (4.7)-
(4.9), each firms profit can be expressed as:

(4.27)
| |
) , , (
) ( ) ( ) ( ). , (
) .( ) , ( ) , , , (
5
2
2
* 1
1
1
2 5 2
3 1 6 4 3 1
A A A A
a A a A a A a a a A
a a A A A A a a a a A Aa
h
q C q C q C q q q T
q q g q q q q d

+
+ =
| |
) , , (
) ( ) ( ) ( ). , (
) .( ) , ( ) , , , (
6
* 1
5
2
4
1
5 5 2
6 4 6 4 3 1 ,
BD BD BD BD
a BD a BD a BD a a a BD
a a BD BD BD BD a a a a BD a D B
h
q C q C q C q q q T
q q g q q q q d

+
+ =
+

(4.28)
where superscript a represents post-alliance. Similarly q denote
cargo quantities served in firm As passenger-cargo network, passenger
numbers carried by A, and cargo quantities in As dedicated cargo network
respectively. denote the related cargo and passenger outputs for
partners B+D.
a a a
q q
3 2 1
, ,
a a a
q q q
6 5 4
, ,
Note that for the aligned partners B+D, the current network structure will
depend on the original parameters of both B and D. That is:
(4.29) )

, ( ), , ( ), , (
D B BD D B BD D B BD
= = =
Then the optimal solution will be given by
, (4.30)
Aa
q q q
a a a
MAX
3 2 1
, ,
a D B
q q q
a a a
MAX
,
, ,
6 5 4
+

For the convenience of analysis, we assume that the demand (both cargo and

25
Rather than focusing on the detailed design or scheduling of cargo network, here we are
more interested in the network change effect on the alliance synergies, which, as we discussed
in the first section, would be evaluated by time, cost and service quality. Accordingly, the
inclusion of these three parameters is reasonable.
26
This is the case of =1 for equation (4.19).
62
passenger) is linear as follows:
) (
6 4 3 1 a a a a A
q q q q d + + + =
, (4.31) ) (
6 4 3 1 ' a a a a BD
q q q q d + + + = 0 ,
'
>

) (
5 2 a a A
q q T + =
, , (4.32) ) (
5 2 ' a a BD
q q T + = 0
'
>
and simplify the inconvenience delay cost as :
( )
a a A A A A A
q q g
3 1
1 ) ( ) , ( + = + =
( )
a a BD BD BD BD BD
q q g
6 4
1 ) ( ) , ( + = + = , 0 , > .
(4.33)
Then, the network structures of firm A and partners B+D are captured by
the parameters and respectively, for example, the wider network coverage
and more frequent flights are related to greater or . Actually in reality, if the
network structure information from both B and D can be captured, after the
alliance, the partners should be able to review the aligned network structure
accordingly. That is, if we know and , then we should apply
the related parameter for the aligned network. It is not that easy to
find an explicit function to describe the relationships, and here we treat
as decision variables in eqn (4.33).
D B
,
D B
,
BD BD
,
BD BD
,
4.4.1 Effects of Network Structure Change
First, we examine the alliance synergies relating to the network coverage
and flight capacity, so we assume service quality as zero.
27
Besides, the
marginal production cost is also assumed linear:
, ,
1 1 1 ' 1
1
1
1 ) ( q q C c =
2 2 2 ' 1
2
2
1 ) ( q q C c =

27
In fact, even if we assume a linear assumption for service quality rather than zero, we
should acknowledge the result is actually the same, since inconvenience cost is also linear.
63
, c ,
3 3 3 ' 1
* 1
3
1 ) ( q q C c =
4 4 4 ' 2
1
4
1 ) ( q q C =
, . (4.34)
5 5 5 ' 2
2
5
1 ) ( q q C c =
6 6 6 ' 2
* 1
6
1 ) ( q q C c =
Here measures the extent of increasing returns to traffic density. An
additional simplification is to set equal to zero.
j

i
h
Since we are concerned with the network design effect on each firm, it is
reasonable to assume these firms compete under the equal situation: their
cargo demands are identical, that is ; the operation costs are assumed
symmetric with . Then the solutions for (4.30) are given by
'
=
=
j

) 3 4 4 4 ( 4 ) 2 ( 4
) 2 4 )( 2 (
2
3 1
+ + + +
+
= =


a a
q q (4.35)

) 3 4 4 4 ( 4 ) 2 ( 4
) 2 4 )( 2 (
2
6 4
+ + + +
+
= =


a a
q q (4.36)

1 ) 2 )( 2 (
) 1 )( 1 (
5 2
5
2


=


a
q (4.37)

1 ) 2 )( 2 (
) 1 )( 1 (
5 2
' 2
5


=


a
q (4.38)

The following Figures 4.4 and 4.5 show the simulation results of how the
output change is related to the network structure parameters. We choose the
feasible value for each parameter to satisfy the second order condition and also
to ensure the positive output for each company.
0.2 0.4 0.6 0.8 1.2 1.4

0.3
0.4
0.5
0.6
0.7
0.8
Q
A

64
Figure 4.4. Cargo output change of firm A, depending on the network
parameter .
Here is the total cargo service quantity of firm A and
A
Q is the
network structure parameter: a network with wider coverage and more
frequent flights is related to a larger . Figure 4.2 assumes
3 . 0 , 5 , 2 . 1 = . 2 = = , and shows the range of 4 . 1 1 . 0 < < .

0.2 0.4 0.6 0.8 1 1.2

0.5
1.5
2
Q
B+D

Figure 4.5. Cargo output change of partners B+D, relating to network
parameter .
Here is the total cargo service quantity of partners B+D and
D B
Q
+
is
the network structure parameter: a network with wider network coverage and
more frequent flights is related to a larger . Figure 4.3
assumes 3 . 0 , 5 . 2 , 6 . 1 = = = , and shows the range for 2 . 1 < 0 < .
These simulation results show that:
Proposition 4.5. If the inconvenience delay cost decreases due to
expanded network coverage or more frequent flights, the cargo market share
increases for either firm A or partners B+D.
Following Figure 4.6 and Figure 4.7 present the cargo output relating to
marginal cost for firm A and partners B+D, respectively.
65
0.2 0.3 0.4 0.5 0.6 0.7

1.5
2
2.5
3
Q
A

Figure 4.6. Cargo output of firm A, relating to marginal cost.

Figure 4.6 is given by assuming 5 . 2 , 2 . 1 , 4 . 1 = = = , and shows the
range of 7 . 0 1 . 0 < < .

0.2 0.3 0.4 0.5 0.6

0.75
1.25
1.5
1.75
2
2.25
Q
B+D

Figure 4.7. Cargo output of partners B+D, relating to marginal cost.

Figure 4.7 is given by assuming 5 . 2 , 2 . 1 , 4 . 1 = = = , and shows the
range of 6 . 0 1 . 0 < < .
From the simulation results, we can state:
Proposition 4.6. With the network structure fixed, if the extent of
increasing returns to traffic density increases (the marginal production cost
decreased), the cargo output increases for both firms.
In fact, Propositions 4.6 and 4.7 are obvious. If we do not consider the
66
effect of the network setup cost, then the more flexible network will logically
bring more cargo quantities. More cargo outputs would be provided if the
marginal cost can be decreased and consumers will be better off due to the
improved network coverage or more frequent flight schedule.
4.4.2 Effects of Network Setup Cost Change
Network setup cost is a critical factor for each firms revenue management.
Here we assume the network setup cost for firm A and partners B+D as:
( ) + =
a a A A A A
q q h
3 1 2
) , , ( (4.39)
( ) + =
a a A A A BD
q q h
3 1 2
) , , ( .
28
(4.40)

The following figures 4.8 and 4.9 show the profit change relating to the
network structure parameters:
0.2 0.3 0.4 0.5 0.6 0.7 0.8

0.35
0.45
0.5
0.55
0.6

A

Figure 4.8. Firm As profit change, relating to network parameter .
Here denotes firm As profit. Figure 4.8 is given by
assuming
A

. 1 05 . 0 , 8 . 2 , 2 = = = , and shows the range of 0 8 . 0 1 . < < .

From the figure, we know that for this detailed case, firm A will get the
maximum profit when 44 . 0 = .

28
We use the quadratic cost function here, which depends on network structure parameter
and
2
. This kind of cost function can ensure a U-shape average cost curve and a marginal
cost that is not constant.

67
0.2 0.3 0.4 0.5 0.6

0.15
0.25
0.3
0.35

B+D

Figure 4.9. Partner B+Ds profit change, relating to network parameter
.
Here denotes the profit of partners B+D. Figure 4.9 is given by
assuming
D B+

. 1 05 . 0 , 8 . 2 , 6 = = = , and shows the range of 0 6 . 0 1 . < < . In

this case, partners B+D will get the maximum profit when 29 . 0 = .
From the simulation results, it is clear that:
Proposition 4.7. Even if the inconvenience delay cost decreases due to the
expanded network coverage or more frequent flights, the profit would not
constantly increase, since this is dependant on the network setup cost.
The above result shows that although the cargo output may be increased
due to the network redesign, the air carrier may not be profitable all the time
since the network setup costs need to be considered. That is why networks do
not blindly extend network coverage and increase flight capacity. Our
simulation result can give the detailed conditions according to which each
carrier can decide the related network structure parameter for the maximized
profit.
In addition, if we consider the relationship between shipment handling
quality and each firms performance, we would get similar results as
Propositions 4.6 and 4.7:
Proposition 4.8. Each firm or partner will earn more cargo outputs if the
shipment handling quality can be improved. However the profit will not
68
increase constantly, but is again related to the network setup cost.
29

To summarize the simulation studies, we found that both firm A and the
alliance partners B+D would produce more cargo outputs owing to the
network expansion, increased flight capacity or improved shipment quality,
which could decrease the inconvenience costs. However, the network redesign
would increase the network setup cost, so the increased cargo outputs may not
bring more profits for the service providers.
4. 5. Summary
In this Chapter, an analytic model is developed to examine the synergy
effect of the alliance between passenger-cargo and dedicated cargo networks.
The model predicts that a cargo alliance between these two networks will
likely earn more cargo service quantities for each network, whilst the rival
non-partner carrier, which owns two different types of networks, would lose
some cargo services. Furthermore, this carrier also loses some profits to the
alliance partners. Results show that the consumer will be better off and the
total social welfare will be increased due to the alliance for symmetric demand.
Simulation studies show that cargo output will be increased if the
inconvenience cost can be decreased under a more flexible network. However,
network redesign may cause additional cost and profits may not be increased.
Conditions are developed for network design decisions in maximizing profit.
The reduction of production cycles leads to the demand for more
consistent and efficient transport services. In order to offer door-to-door
express deliveries and more reliable, accessible, standardized and qualitative
services, combination carriers will consider developing and maintaining their
dedicated air cargo networks. This study supports the idea from a theoretical
perspective, and also provides some suggestions for airlines to optimize their
service networks.

29
The detailed simulation figures are omitted since it is very similar to the inconvenience
delay cost case.
69
Chapter 5 Competition Models in
Intermodal Transport Logistics
Intermodal refers to the use of two or more modes of transportation for
the continuous movement of freight from the origin shipper to destination
receiver. The most common modes of intermodal transport are trucking, rail,
sea and air. Over the last few years, intermodal logistics has emerged in the
marketplace to meet the demands of global trade and the rapid evolution of
information technologies, which permit service providers to assemble multi-
functional information and coordinate different modal services. To some
extent, intermodal logistics is not new. Freight carriers have sought integration
between different transport modes, and third party service providers have
arranged serial transport for decades.
This chapter develops an intermodal alliance model to evaluate the
competitiveness of traditional freight forwarders and integrators in the air
cargo market. Traditional airfreight mainly operates in a forwarder-airline-
forwarder format, in which airlines provide an airport-to-airport service and
forwarders handle the rest of the transport logistics such as land transport. The
integrator is a single company with full control of door-to-door shipment that
provides track and trace facilities for customers making use of its own
information technology setup. In the model, the intermodal alliance is formed
between the forwarder, ground transport company and airline, and we
investigate the intermodal integration of the rivalry between an integrator and
a forwarder-airline alliance. The alliance effects on each firm (partner)s
output, profit and total social welfare are examined by comparing the
outsourcing, non-alliance model to the alliance model.
5.1 Introduction
The air cargo industry has developed rapidly over the past 25 years and
70
international traffic has grown faster than domestic business.
30
There has been
an increasing focus on the logistics of moving goods via intermodal systems
and within multimodal environments. In order to be more competitive and
efficient, the traditional service providers in the cargo industry have to
enhance their roles and adjust business strategies to face challenges from new
competitors. Accordingly, the composition of the airfreight industry has
changed dramatically during this time, since the integrated all-cargo carriers
captured virtually all of the cargo growth and became the industry leaders.
Before 1990, the airfreight industry largely consisted of agents whose
primary roles were to provide point-to-point transportation, customs clearance
and storage services, and whose main assets were trucking vehicles and
warehouses. It was impossible for these agents to provide a global service
network or integrated services, since they were typically limited to serving a
segment of the total logistical services. At that time, the traditional airfreight
mainly operated in a forwarder-airline-forwarder format, in which airlines
provided airport-to-airport transport services and forwarders handled the rest
of the transport logistics. Freight forwarders functioned as third-party
brokers/operators who contracted with shippers and coordinated and managed
the cargo shipment.
Since then, the Internet has brought dramatic changes to this industry. e-
commerce enabled business to sell their products worldwide, typically in small
quantities (Jutla et al. 1999, Tenenbaum, Chowdhry and Hughes 1997, Auger
and Gallaugher 1997). Further, the internet enriched the concept of supply
chain management to establish a new business paradigm of integrated logistics
activities and alliances with suppliers and customers (Lee and Billington 1995,
Chiu 1995, Williams et al. 1997, Sowinski 1999). Nowadays, many enterprises
outsource their logistics needs to specialist logistics agents who have become
vital partners in managing supply chains (Razzaque and Sheng 1998).
Enterprises often demand a one-stop total logistics service that is integrated,

30
Air Transportation Association (ATA) annual reports showed the Freight and Express Ton-
miles (thousands) for U.S. Air Carrier Scheduled Services have tripled from 4,795,308 in 1975
to 21,143,000 in 2000; while the revenues (thousands) increased more than six fold from
$1,309,779 to $11,993,000 during this period.
71
reliable, and web-based. Consequently, integrators have expanded their
presence by moving into the higher, value-added express, door-to-door
services. Nowadays, the four largest integrators: Federal Express, UPS, DHL
and TNT account for about 90% of the worlds air express, door-to-door
market. They have introduced new levels of service standards via extensive
use of information technology and a comprehensive global network (Melbin
1997, Hamilton 1997, Chu et al. 2004).
The strong challenge of integrators has led to strategic responses from
other service providers.
31
Because worldwide demand for airfreight-friendly
high-value, short-shelf-life products is soaring, these are halcyon days in
which to be an airfreight forwarder. Significantly, forwarders are forming
partnerships with airlines and couriers for door-to-door service or by
consolidation through mergers (e.g. AEI, Danza and DHL), and becoming
more focused on end users. Moreover, a few combination carriers have entered
the air express, door-to-door market by forming partnerships with freighter
and shipping companies, or with express operators. China Southern Chinas
largest passenger airline is a recent example of a passenger carrier moving to
surface-air intermodal integration. In 2002, the three global airfreight alliances
New Global Cargo, SkyTeam Cargo, and Oneworld accounted for 19.9%,
14.9%, and 13.9% of international traffic respectively (in terms of freight
tonne kilometers). However, there is no research available that focuses on the
economic effect of the alliance between forwarders and airlines in the air
freight market, and no one has considered the competition between forwarder
and integrator. From the public policy point of view, it is important to
understand the effects of such alliances, and their associated benefits in
intermodal integration and users welfare.
There are number of studies of airline alliances in the context of oligopoly

31
The integrators have successfully followed the strategy of offering superior service at a
premium price. By providing time-definite, guaranteed door-to-door service supported by the
real-time shipment tracking service, they are able to earn a yield of about $2.00 to $2.50 per
pound for domestic shipments. However, their leading competitors, combination carriers,
providing airport-to-airport service mainly on a space-available basis, normally provide no
service guarantees and earn only $0.30 to $0.40 per pound for domestic freight.

72
related to this research work (e.g. Oum et al. 2000, Brueckner and Whalen
2000, Brueckner 2001, and Ito and Lee 2004). However, all these studies
focus on passenger alliances. This thesis examines the effect of intermodal
integration on the competition between an integrator and a forwarder-airline
alliance in the air cargo market. The effect of the alliance among forwarder,
transport company and airline, is also investigated. Naslung (1970) considered
the problem of combined sea and land transportation, and illustrated how the
mixed-integer warehouse location problem can be applied to the pulp industry.
More recently, Arnold et al. (2004) considered the problem of optimally
locating rail/road terminals by modeling a rail/road transportation system.
However these studies do not focus on oligopolistic rivalry and it appears that
there are no published alliance papers that examine intermodal transportation
and the rivalry between forwarders and integrators.
5.2 Basic Model
As depicted in Figure 5.1, we consider a simple multimodal cargo service
network. There are three nodes A, B and C, comprising three origin and
destination markets, namely AB, BC and AC. We assume there are different
transport modes associated with AB and BC, for example, ground
transportation of cargo for AB and air transportation of cargo for BC. These
two single-mode markets may be referred to as local markets. In contrast,
market AC involves two different modes of transportation (ground, air) and
may be referred to as a multimodal market.


A B C

Local market AB Local market AB
Multimodal market AC
Figure 5.1. A simple cargo transport network.

73
There are four companies: (i) an integrator, denoted I, serves all three
markets; (ii) a ground transportation company, G, serves the AB market; (iii)
an airline, N, serves the BC market; and (iv) a forwarder, F, serves the AC
market. Except for integrator I, which can provide each kind of cargo service
in all three markets, we assume companies G, N and F can serve only their
respective markets.
32
Note that as forwarder F does not have physical
operations at AB and BC, it has to use the services of G and N to move its
cargo in the AB and BC segments. For the two local markets, the inverse
demand functions may be written as:
( ) ( )
j
BC
i
BC
i
BC
i
BC
j
AB
i
AB
i
AB
i
AB
Q Q d P Q Q d P , , , = = i j i = . 2 , 1 (5.1)
where the superscripts denote firms: 1 = i for the integrator; and i for G in
the AB market, whereas for N in the BC market.
2 =
On the other hand, if carrying the cargo from A to C, the combination
modes of a ground mode on the AB segment and an air mode on the BC
segment, have to be used. Connections must be made at node B. Assuming
that shippers place a dollar value on the quality of connections between the
two modes, demands in the AC market may be written as:
( ) j i i D Q
j
AC
i
AC
i
AC
i
AC
= = . 2 , 1 , , (5.2)
where the superscripts again denote firms: 1 = i for the integrator; and 2 = i
for the forwarder. In the above demand functions, is the full price of
using i s service, which is the sum of its price (freight tariff), denoted as ,
and the cost of poor quality connections incurred by the shippers, denoted
as
i
AC

i
AC
P
i
. That is, . Solving the demand functions for may
yield the following inverse demand functions:
i
i
AC
i
AC
P + =
i
AC

( )
j
AC
i
AC
i
AC
Q Q d , =
i
AC
. (5.3)

32
This may be due to the license requirement: sometimes the operating license is regionally
restricted. For example, in China, separate licenses (e.g. Class A freighters in forwarding
business) are required for ground transport, air transport, shipping, bonded warehousing,
customs clearance and related services, and the licensing requirements differ region by region
(Zhang et al. 2004).
74
In each of the three markets, outputs of the rival firms are assumed to be
substitutes:
. , , , , 0 j i AC BC AB k
Q
d
j
k
i
k
= <

(5.4)
Note that in (5.4), the outputs can be, but need not to be, perfect
substitutes. We further assume that in each market their outputs are strategic
substitutes using the term of Bulow et al. (1985). That is,
. , , , , 0
2
j i AC BC AB k
Q Q
j
k
i
k
i
= <


(5.5)
Thus, in each market a firms marginal profit decreases as the output of its
competitor increases.
) (
1
Q C
AB
and are used to denote the integrators cost function in
segments AB and BC respectively. Q represents total cargoes carried by the
integrator in a given segment, which includes both the local (say, AB) and
multimodal (AC) shipments. Given these demand and cost specifications, the
integrators profit can be expressed as:
(Q C
BC
1
)

( ) ( ) ( ) ( )
( ) ( ) ( )
1 1
1 1 1 1 1 1
1
2 1 1 1 2 1 1 1 2 1 1 1 1
, , ,

g Q Q C Q Q C
Q Q d Q Q Q d Q Q Q d Q
AC BC BC AC AB AB
AC AC AC AC BC BC BC BC AB AB AB AB
+ +
+ + =


(5.6)
where ( )
1 1
g
0 <
denotes the overhead cost which depends on the quality of
integration (but is independent of the levels of outputs produced), with
. ( )
1
'
1
g
As indicated earlier, since F does not physically operate at segments AB
and BC, it must use the services of G and N to move its cargo in the AB and
BC segments. C and ( ) Q
AB
2
( ) Q
BC
2
C are used to denote the costs of firms G and
N, respectively. Their profits may be written as:
( ) ( ) ( )
2
2 2 2 2 1 2 2
,
G AC AB AB G AB AB AB AB
G
g Q Q C w Q Q d Q + + = (5.7)
75
( ) ( ) ( )
2
2 2 2 2 1 2 2
,
N AC BC BC N BC BC BC BC
N
g Q Q C w Q Q d Q + + = (5.8)
where ) (
2

i
g
0 <
are the integration overhead costs for each firm, with
; and w and denote the forwarders compensations to G and
N, respectively. Finally, forwarder Fs profit is given by:
) (
2
'

i
g
G N
w
( ) ( ) ( )
2 2
2 1 2 2
,
F N G AC AC AC AC
F
g w w Q Q d Q = (5.9)
where ) (
2

F
g
0 ) (
2
<
) (
' '
Q C
i
k
0
' '
<
is the integration cost incurred by the forwarder,
with . We assume the segment cost function, C , reflects
increasing return to traffic density, with C and C . Note that the
total cost for each segment comprises variable costs and fixed costs, so the
economies of traffic density can come from two sources: falling marginal costs
and spreading fixed costs over more traffic. In the following analysis we shall
consider , that is, the marginal costs decline as total traffic on a
give route segment k (k = AB, BC) increases. In particular, if the load factor for
a carrier (aircraft flight or truck etc.) is raised by more traffic volume (from
both the local and multimodal shipments), then the unit costs could be
decreased by the greater vehicle space used. This would be the case when a
carrier is supposed to keep a minimum level of vehicle / shipment frequency
due to the competition or service quality limitation. Alternatively, the
increased vehicle size afforded by increased traffic volume on a given route
may give C . This would likely be the case when the cost per seat in the
aircraft declines as the aircraft size increases. Some researchers have
addressed the declining marginal costs on the route level, for example,
Brueckner and Spiller (1991) discuss the network effect of airline hubbing;
Adler and Berechman (2001) show that as flight frequency increases, the
additional cost per flight decreases. They also explore the implications of
falling marginal costs (in flight) for optimal airline networks.
'
F
g ) (Q
i
k
0 0 ) (
'
> Q
' '
<
0 <
5.3 Effects of Alliance and Intermodal Integration
In this section, we examine the intermodal integration effect on the rivalry
76
between the integrator and the alliance, which is formed by the forwarder F,
ground transportation company G and airline N. As previously discussed,
integrators are large, well-financed enterprises with very strong systems and
they have an important competitive advantage over the forwarders.
Forwarders rely on the scheduled airlines for a critical link in their service
chain, and better cooperation between them is the only way for forwarders to
survive. Nowadays, the intermodal alliances allow carriers to extend their
routings and networks, and more importantly, they offer the end-customer one-
stop shopping and have the best routing for a particular shipment. For
simplicity, the alliance is referred to as a forwarder-airline alliance and the
partners F+G+N would maximize the joint profit maximization rather than
operate separately.
Using
F N G
+ +
2
, ) ( ) ( ) ( ) (
2 2 2 2 2

F N G
g g g g + + , and
equations (5.7)-(5.9), the alliances joint profit can be written as:
( ) ( ) ( ) ( )
( ) ( ) ( )
2 2
2 2 2 2 2 2
2
2 1 2 2 2 1 2 2 2 1 2 2 2
, , ,

g Q Q C Q Q C
Q Q d Q Q Q d Q Q Q d Q
AC BC BC AC AB AB
AC AC AC AC BC BC BC BC AB AB AB AB
+ +
+ + =


(5.10)
where ( )
2 2
g
0 <
denotes the total integration overhead cost for the alliance, with
. ( )
2
'
2
g
For simplicity, we refer to the integrator and the forwarder-airline
alliance each as a chain. Specifically, the integrator I is chain 1, and the
alliance is chain 2. Consequently these two chains would compete with each
other in all markets. We now consider the intermodal integration effect,
i
, on
their rivalry, by considering an equilibrium that arises when each chain
chooses output quantities to maximize its profit:

( )
1
2 1 1 1
; ,
1
Q Q Max
Q
=


( )
2
2 1 2 2
; ,
2
Q Q Max
Q
=

77
where ( )
i
AC
i
BC
i
AB
i
Q Q Q , , Q denotes the output vector for 2 , 1 = i . The resulting
Cournot-Nash equilibrium is characterized by the first-order conditions
(subscripts denoting vector partial derivatives),

( ) 0 ; ,
1
2 1 1
1
= Q Q
(5.11)

( ) 0 ; ,
2
2 1 2
= Q Q
2

(5.12)
and the second-order conditions, that is, the following 33 Hessian matrices
are negative definite:

(
(
(
(

i
c c
i
b c
i
a c
i
c b
i
b b
i
a b
i
c a
i
b a
i
a a
i
ii
i i i i i i
i i i i i i
i i i i i i
where subscripts a, b and c represent for notational simplicity AB, BC and AC
markets, respectively. In addition, regularity conditions are imposed so that the
equilibrium exists and is stable.
It can be easily shown that 0
2
=


i
BC
i
AB
i
Q Q
, implying that there is no
strategic complementarity between the two local transportation services. We
can also show:
( ) . , , 0 .
' '
2
BC AB k C
Q Q
i
k i
AC
i
k
i
= > =


(5.13)
This means for a given chain, the marginal profit of local traffic increases in
its multimodal traffic and vice versa, which implies there are strategic
complementarities between local and multimodal shipments. Besides, it also
shows that the decreasing marginal costs, C , at the segment level
would increase these complementarities.
( ) 0 .
' '
<
i
k
We turn now to the implications of the cross-market relationships in (5.13)
for intermodal integration in an oligopolistic environment. The following
propositions give the detailed alliance effects on each chains quantities, profit
changes, and also the social welfare.
78
Proposition 5.1. As a chain (the integrator, or the forwarder-airline
alliance) improves its intermodal integration, it will produce more outputs,
whilst its rival chain will produce less outputs, in all three markets, i.e.,
0
) , (
, 0
) , (
2 1 2 1
>

<

i
j
i
i
Q Q

, j i i = , 2 , 1 . (5.14)
Here and (
2 1
1
, Q ) ( )
2 1
2
, Q denote the effects of intermodal integration
variables ( )
2 1
, on the equilibrium quantities for chain 1 and 2 respectively.
The proofs of Proposition 5.1 and other propositions of this section are
given in Appendix B.
Proposition 5.1 says the intermodal integration quality is critical for each
chain to obtain more market share from both the local and multimodal markets.
As one chain improves its integration, it will increase its own outputs, while
simultaneously reducing its rival chains outputs, not only in the multimodal
market but also in the two local, single-mode markets. Better integration will
stimulate the chain to serve more multimodal shipments, and this will allow
the chain to earn more shipments in the local markets because the marginal
profit of local traffic increases in its multimodal traffic. Given that the chains
commitment to greater outputs in the three markets is credible, the best
response of the rival chain is, under strategic substitutability, to service less
shipments in all three markets.
The following result shows that intermodal integration helps a chain earn
greater profit.
Proposition 5.2. As a chain (the integrator, or the forwarder-airline
alliance) improves its intermodal integration, it will earn greater profit while
its competitor will earn less profit.
Note that Proposition 5.2 further indicates that intermodal integration can
also be used by one chain to harm another. Both propositions suggest that
intermodal service quality is a critically competitive factor in todays highly
competitive airfreight market. Multimodal integration helps a chain gain
strategic advantages in both market-share rivalry and profitability. Weak
79
integration capability can, on the other hand, marginalize a chain.
From the public policy point of view, it is important to understand the
effects of alliance and intermodal integration on full prices (freight tariffs plus
the inconvenience costs from poor intermodality) and users welfare. However,
it is impossible to calculate a clear result relating to the total output change in
each market from Proposition 5.1, since one chain increases its output whilst
the rival chain decreases its output. To examine this full price/total output
effect we consider homogeneous products in which the two chains provide
perfect substitutes in each market, and the symmetric case where the chains
face symmetric demands in each market.
Proposition 5.3. For the symmetric case and homogenous products, an
improvement in intermodal integration results in (i) increased total output,
and (ii) decreased full prices in all three markets. Consequently, shippers
would be better off.
Finally, we examine the impact of integration improvements on total
economic surplus, which is the sum of consumer (user) welfare and the firms
profits. As the above results indicate, the users are likely to gain, the chain that
improves its integration gains, but the other chain may lose. To examine the
impact on total welfare, we consider a partial equilibrium framework in which
consumer demand for cargo in each market is derived from a utility function
which can be approximated by the form:

( ) AC BC AB k z Q Q U
k k
k
k
, , , ,
2 1
= +

where is expenditure on a competitively supplied numeraire good, and z
i
k k
u =
i
k
Q . Then consumer surplus in each market can be written as:

( )
2 2 1 1 2 1
,
k k k k k k k k
Q Q Q Q U = CS
(5.15)
and the total surplus as:

2 1
+ + =

k
k
CS W . (5.16)
Substituting (5.6) and (5.10) into (5.16) then yields:
80
. (5.17)
( ) ( ) ( | |
( )
i
i
i
i
AC
i
i
k i
i
AC
i
BC
i
BC
i
AC
i
AB
i
AB k k k
g Q
Q Q C Q Q C Q Q U W



= =
=

+ + + =
2
1
2
1
2
1
2 1
, )
Proposition 5.4. For the symmetric case and homogenous products, total
welfare rises as intermodal integration improves.
Thus, a better (service) quality of intermodal integration will benefit the
chain (the integrator, or the forwarder-airline alliance) which undertakes the
improvement, while harming the rival chain. Besides with reasonable
symmetry between the two chains, the shippers would be better off with the
improvement of intermodal integration, and the whole social welfare will
increase as well. All the propositions suggest that intermodal service quality is
a very important factor for forwarders to compete with integrators in
delivering multimodal shipments.
The integration quality could be improved, for example, by improving the
information platform. In 2003, Unisys Corporation announced break-through
collaboration with three major international airline carriers to deliver Cargo
Portal Services, a comprehensive Internet portal that will offer reliable cargo
services to freight forwarders. United Airlines Cargo, Northwest Airlines
Cargo and Air Canada Cargo combined their resources with Unisys to provide
forwarders with a new and efficient way to manage a shipment through its
transport and delivery cycle. The full, multi-carrier service will launch by
year-end.

5.4 Effects of Alliance and Competition
In the previous section, we have assumed a given forwarder-airline
alliance so as to focus our analysis on the effects of intermodal integration.
Facing the challenge from integrators, the success of individual freight
forwarders is supposed to depend on their ability to integrate with their
customers. In this section, we compare a forwarder outsourcing, non-alliance
81
model with a forwarder-airline alliance model to investigate how effective the
alliance could be, and the competition between forwarder and integrator in
multimodal market will be examined by comparing their respective market
shares, profits and other economic performances.
For this purpose, we consider a situation in which forwarder F, the ground
transportation firm G, and airline N remain independent, in the sense that each
firm maximizes its own profit rather than their joint profit. These firms then
compete with the integrator in the three markets. In examining this four-firm
rivalry we shall, for simplicity, assume equal service quality and set all the
i
s to equal zero.
Referring to the equations (5.7)-(5.9), these denote the profits for firms G,
N and F respectively. Note that the forwarder will compensate transport
company and airline according to and respectively. One natural form
for these compensations is that they depend on both the forwarders cargo
quantities, , and the prices (freight tariffs) prevailing in the respective
segments. More specifically, we shall consider the following linear forms:
G
w
N
w
2
AC
Q

w
(5.18)
) (
2 2
AC AB AB G
Q P =

w
(5.19)
) (
2 2
AC BC BC N
Q P =
with
AB
and
BC
being positive constants. Parameters
AB
and
BC
may be
interpreted as rates: e.g., when 1 <
AB
, the trucking company offers a
discount to the forwarder. Similarly, the forwarder receives no discount (or
premium) with 1 =
AB
, and a premium with 1 >
AB
.
33
Note that total
compensations and likely differ from each other, owing to different
features of the AB and AC markets. However, firms G and N may be given the
same rate,
G
w
N
w
BC AB
= .

33
An alternative way to interpret is: when < 1, the forwarder offers a discount to the
service agent. Similarly, the forwarder offers no discount (or premium) with =1, and a
premium with > 1.
82
With zero
i
and referring to (5.18) and (5.19), the profit functions of
firms G, N and F become, respectively,
( ) ( )
2 2 2 2 2 1 2 2 1 2 2
) , ( ,
AC AB AB AC AB AB AB AB AB AB AB AB
G
Q Q C Q Q Q d Q Q d Q + + =

(5.20)
( ) ( )
2 2 2 2 2 1 2 2 1 2 2
) , ( ,
AC BC BC AC BC BC BC AC BC BC BC BC
N
Q Q C Q Q Q d Q Q d Q + + =

(5.21)
2 2 1 2 2 2 1 2 2 1 2 2
) , ( ) , ( ) , (
AC BC BC BC AC AC AB AB AB AB AC AC AC AC
F
Q Q Q d Q Q Q d Q Q d Q =
.
(5.22)
The integrators profit, on the other hand, remains as expression (5.6)
(with
i
being replaced with zero). We consider a product-market equilibrium
that arises when, for given
AB
and
BC
, each of the four firms chooses output
quantities to maximize its profit. The resulting Cournot equilibrium is
characterized by the following first-order conditions:
(
1 1
'
1 1
1
1
1
AC AB AB AB
AB
AB
AB
Q Q C Q
Q
P
P + =

+ ) (5.23)

( )
1 1
'
1 1
1
1
1
AC BC BC BC
BC
BC
BC
Q Q C Q
Q
P
P + =

+
(5.24)
( ) (
1 1
'
1 1 1
'
1 1
1
1
1
AC BC BC AC AB AB AC
AC
AC
AC
Q Q C Q Q C Q
Q
P
P + + + =

+ ) (5.25)
(
2 2
'
2 2 2
2
2
2
) (
AC AB AB AC AB AB
AB
AB
AB
Q Q C Q Q
Q
P
P + = +

+ ) (5.26)
(
2 2
'
2 2 2
2
2
2
) (
AC BC BC AC BC BC
BC
BC
BC
Q Q C Q Q
Q
P
P + = +

+ ) (5.27)

2 2 2
2
2
2
BC BC AB AB AC
AC
AC
AC
P P Q
Q
P
P + =

+ . (5.28)
Note that (5.23)-(5.25) represent the earlier equations (5.11), the first-
order conditions for the integrator in the three markets, whereas (5.26)-(5.28)
83
are those for G, N and F respectively. In these equations, the left-hand sides
are marginal revenue in node-pair markets which are set equal to marginal cost
given by the right-hand sides of the equations.
We are interested in comparing the differences of cargo quantities between
the integrator and G, N and F in their respective markets. For simplicity of
analysis, we assume the demand and marginal cost are symmetric between
forwarder and integrator. Consider the AB market first. Comparing (5.23) with
(5.26), we see that firm G has an additional term, namely,
2
2
2
AC
AB
AB
AB
Q
Q
P

, in its
marginal revenue. Owing to the downward-sloping demand function,
0
2
2
<

AB
AB
Q
P
2
AB
Q <
, and the second-order condition and falling marginal cost, we can
get , i.e., firm G has a smaller market share in the AB market than
the integrator. Similarly, we can show that firm N has a smaller market share
in the BC market than the integrator.
1
AB
Q
Next consider the multimodal market, AC. Subtracting (5.28) from (5.25)
we obtain

( ) ( ) ( ( )
1 1
'
1 1 1
'
1 2 2
1
1
1
2
2
2
1 2
) ( ) (
AC BC BC AC AB AB BC BC AB AB
AC
AC
AC
AC
AC
AC
AC AC
Q Q C Q Q C P P
Q
Q
P
Q
Q
P
P P
+ + + + =

+
)
)
. (5.29)
If we assume homogeneous products in the AC market, i.e., ,
then
AC AC AC
P P P = =
2 1


( ) ( ) ( ( ) | |
' 1 1
'
1 1 1
'
1 2 2
1 2
AC AC BC BC AC AB AB BC BC AB AB
AC AC
P Q Q C Q Q C P P
Q Q
+ + + + =


.
(5.30)
Note that ( ) ( )
1 1
'
1 1 1
'
1
AC BC BC AC AB AB
Q Q C Q Q + + +
2 2
BC BC AB AB
P P +
C is the integrators marginal cost in
the AC market, while is the sum of the forwarders marginal
payments to firms G and N for transporting its cargo between nodes A and C.
84
Thus, using (5.30) we obtain the following result.
Proposition 5.5. Assuming no alliance among the forwarder F, the
ground transportation firm G and the airline N, and other model
specifications of this section.
1) The forwarder will have greater market share in the multimodal
market if, and only if, its marginal payment to G and N is less than
the integrators marginal cost in this market.
2) Assume that the forwarder is unable to receive a discount rate from
the two transportation firms, i.e., 1
AB
and 1
BC
, then
. If the forwarder must pay at least the rates prevailing in
the two segment markets to G and N, then it will have a smaller
market share than the integrator.
1 2
AC AC
Q Q <
Generally, even with large discount rates, we may predict that the
forwarder is to have a smaller market share than the integrator. This is because,
as discussed above, in the two local markets, transport company G and airline
N own smaller amounts of shipments than the integrators respective segment
markets. With the economies of traffic density fixed, smaller local outputs will
bring larger marginal cost of carrying multimodal shipments, which further
reduces the equilibrium output for the forwarder. Similarly, the lower
multimodal output will increase the marginal cost of carrying local shipments,
and accordingly local equilibrium outputs would be decreased. That is, the
absence of a strategic alliance among the forwarder, the trucking firm and the
airline would, provided the discount rates are not too large, result in lower
output quantities in all three markets. Furthermore, this output difference will
increase as the economies of density become stronger.
5.4.1 Simulation study on market share and profit
The above analysis suggests that, from a market-share rivalry point of
view, a sufficient condition for the forwarder to outsource its multimodal
cargo to local segment operators, rather than to form a strategic alliance with
85
them, is that it could offer a significantly large discount to those servicing
operators. To better understand the problem we carry out the following
sensitivity analysis. Specifically, assume homogenous products in each market,
identical costs, and linear demand and marginal cost functions:


( ) 0
,
> =
i i i
Q Q P
(5.31)

C
(5.32)
( ) 0 , 1
'
> =
j j j
Q Q
where denotes market (there are three markets) and denotes segment
(there are two route segments). Further,
i j
i
represents the level of demand,
and
j
measures the extent of increasing returns to traffic density, with large
values of
j
representing stronger density economies. Given these specific
functional forms and assuming, for simplicity, = =
BC AB
, explicit
solutions to the Cournot equilibrium can be obtained:

( ) ( )
( )( )
AB AB
AB AC AC AB AB
AB
AB
AB
Q Q
Q

+
+

=
3 1
2
3
1
2 1
1
(5.33)

( ) ( )
( )( )
BC BC
BC AC AC BC BC
BC
BC
BC
Q Q
Q

+
+

=
3 1
2
3
1
2 1
1
(5.34)

( )( )
( )( )
AB AB
AB AB AC AC AB
AB
AB
AB
Q Q
Q

+
+

=
3 1
2
3
1
2 1
2
(5.35)

( )( )
( )( )
BC BC
BC BC AC AC BC
BC
BC
BC
Q Q
Q

+
+

=
3 1
2
3
1
2 1
2
(5.36)
whereas detailed expressions for Q and are quite complex and are
given in equations (B.15)-(B.17) in the Appendix B.
1
AC
2
AC
Q
The simulation results for 6 . 0 = =
BC AB
are given in Table 5.1. In the
table, we have for simplicity assumed =
BC AB
, and
= =
AC BC AB
. The second-order conditions then reduce to 3 / 2 < .
However, the output comparison is still complicated due to different values of
86
economic density and demand level . In particular, to have a proper
solution, parameters and must be chosen to ensure both positive
quantities and positive marginal revenues. Restricted by the second-order
condition and the proper-solution requirements, the simulation is conducted
for 0.4. Then for each given value of , the second column in the table
shows the feasible range for demand level to ensure a proper solution.

>



Feasible Range of

Bound on to get
positive Q for
Forwarder
Bound on to get
positive Profit for
Forwarder
0.01 2.233< 2.233<<2.805 2.233<<2.809
0.02 2.223< 2.223<<2.778 2.223<<2.784
0.03 2.214< 2.214<<2.751 2.214<<2.760
0.05 2.194< 2.194<<2.699 2.194<<2.713
0.1 2.147< 2.147<<2.576 2.147<<2.601
0.15 2.100< 2.100<<2.463 2.100<<2.495
0.18 2.078< 2.078<<2.400 2.078<<2.434
0.2 2.061<<18 2.061<<2.360 2.061<<2.394
0.25 2.021<<6.316 2.021<<2.263 2.021<<2.298
0.3 1.984<<4 1.984<<2.174 1.984<<2.207
0.35 1.949<<3.014 1.949<<2.090 1.949<<2.119
0.4 1.916<<2.471 1.916<<2.012 1.916<<2.034

Table 5.1. Comparison of cargo quantities between the forwarder and
the integrator.

The third column of Table 5.1 gives the ranges where, after taking the
feasible range of into account, the forwarder has a greater market share
than the integrator. For example, for the case of 01 . 0 = , the forwarder will
have a greater output than the integrator when 2 805 . 2 233 . < < , but have a
smaller output when 805 . 2 . The fourth column gives the ranges where the
forwarder earns more profit than the integrator. The column thus shows that
when the market demand level is reasonably high, the integrator would have a
greater market share than the forwarder, and also be more profitable. Only for
87
lower levels of demand, would the forwarder have a greater market share.
Furthermore, the simulation shows that when the economies of traffic density
become stronger (i.e., greater ), the bounds on demand level to ensure
greater output for the forwarder get tighter.
. 0
During the above analysis, we focused on how the market size and the
intensity of economies of traffic density affect the rivalry between the
forwarder and the integrator, with the discount rates fixed. These results are
consistent with our discussion that follows after Proposition 5.5; that is, the
effects of economies of traffic density become more significant as both and
get larger. The integrator is in a better position than the forwarder to take
advantage of these effects, because it can internalize the complementarities
between its local and multimodal traffic. An independent forwarder is, on the
other hand, unable to do that.
5.4.2 Simulation study on deciding the discount rate
In the above analysis, we have fixed the discount rates at 6 = so as to
focus on the market share rivalry between the forwarder and the integrator,
and on how the different outsourcing models affect this rivalry. As discussed
earlier, the integrator will win this market share rivalry unless the forwarder is
able to receive substantial discounts from transportation firms G and N (G+N).
It is obvious that forwarders profit is depended on the discount rate . The
smaller discount rate , the better return to the forwarder. However, this
discount rate should be large enough to ensure the positive profits earned for
firms G and N to undertake Fs jobs.
However, it is difficult to give a general solution for F in choosing an
optimal given this participation constraint. To illustrate this better, we
consider a detailed case with = 0.02 and = 2.5, F outsourcing the jobs to G
and N. Referring to the following Figure 5.1, this shows that a participation
constraint condition for G and N would be 0.647 < < 0.749, since only under
this, G and N could be profitable by cooperating with forwarder F. However,
Figure 5.2 shows under this range, forwarders profit rises as falls. Then in
88
this case, the optimal discount rate for the forwarder would be =0.647.
0.55 0.6 0.65 0.7 0.75 0.8

-0.04
-0.03
-0.02
-0.01
RF

Figure 5.2. Participation Constraint Function for transportation firms
G and N, relating to discount rate.

0.5 1 1.5 2

0.5
1
1.5
2
PI
F

Figure 5.3. Forwarder Fs profit change relating to discount rate.

As discussed earlier, the integrator will win the market share rivalry
unless forwarder is able to receive substantial discounts from transportation
firms G and N. This suggests that for the outsourcing, non-alliance model to
arise, G and N are likely to have lower costs than the integrator in operating
and transporting freight on their respective segments the lower costs would
then allow the forwarder to receive (or offer) those discounts. Otherwise, we
would expect that the forwarder forms a strategic alliance with G and N.
Alternatively, we might imagine a situation where there are several Gs
and Ns with differing costs depending on individual transport jobs. By not
committing to a long-term alliance with one G and one N, the outsourcing
89
model allows a forwarder who has various kinds of transport jobs over time, to
choose the best (i.e., lowest cost) G and N for each individual job. Thus, while
being unable to internalize the complementarities between the local and
multimodal traffic arising from economies of traffic density, the outsourcing,
no-alliance model offers flexibility and related cost advantages over the
alliance model. In fact, intermodal integration among different types of
service providers in the airfreight industry has become very common during
the last two decades. Even airlines consider forming alliances with other types
of service providers, such as trucking or marine. Some of them are designed to
assist 3PLs, transportation brokers and shippers.
5.6. Summary
In this chapter, a strategic alliance model is developed to evaluate the
competitiveness of traditional freight forwarders and integrators in the air
cargo market. The results show that having a better (service) quality of
intermodal integration will benefit the chain that undertakes the
improvement, whilst harming the rival chain. The analysis indicates that with
reasonable symmetry between the two chains, intermodal integration
decreases full prices in all markets and increases total social welfare.
It is also found that when compared to the alliance case, the outsourcing
with non-alliance partners would, in general, result in a lower market share for
the firms involved than forming an alliance, especially when the market
demand increases. In order to be more competitive, the forwarder has to
choose the best transport firms which have cost advantages over the integrator
in the local markets and accordingly offer substantial discount rates to the
forwarder.
This study shows that integration among forwarders and other logistics
service providers is necessary for forwarders to succeed in competing with
integrators. Decision rules are presented for forwarders to select the right
partners for more profits.
Land (rail and road) and river/sea transport are major components in cargo
90
logistics between Hong Kong and her hinterland Southern China. This model
suggests that intermodal integration among air freight, land and sea is critical
for continuing development of Hong Kong as an air-cargo hub. It is essential
for Hong Kong Government to work with China Government in developing
the necessary physical and IT infrastructure to facilitate integration and
consolidation of multimode shipments.
91
Chapter 6 Conclusions
Global strategic alliances among airlines are now popular as a means of
reaping the benefits of consolidation by alleviating the regulatory restrictions
on access to foreign markets and as a vehicle to improve profitability. Earlier
research in strategic airline alliances was mostly empirical and dealt with the
government policy issues, the major areas of joint activities and coordination
between partners, and the performance of strategic collaborations. These
studies were mainly focused on passenger services and ignored the service
network structure. This thesis develops several decision models to study the
strategic alliance of both passenger and cargo services from a network
integration approach, and provides methodologies for the airline industry to
analyze the formation of strategic alliances, for the selection of strategic
partners and for governments and regulatory bodies to determine the financial
and social consequences of such alliances.
The forming of international airline alliances has been an important
strategy for airlines to expand service networks without the need to acquire
new resources or to raise significant capital to fund such developments.
However, are these alliances profitable to the partners? What is the effect on
the rival airlines? What are the impacts on the governments and the consumers?
The first model examines the effects of the international alliance on each firm
(both partner and non-partner)s output, profit and total social welfare. Results
show that the alliance will bring more output to both the partners and the
competitors in the international market. However the alliance has no effect on
the non-partner rivals in two domestic markets. Different conditions were
identified under which the partners can earn more profits, the consumer will
be better off, and the social welfare will be increased. Both government
agencies and airline companies can apply the research results in examining the
alliance proposals.
Nowadays, the air cargo industry is facing many new challenges where
shippers are demanding reliable, integrated, global and standard services in air
92
transport. Combination carriers carry cargo in the belly space of the passenger
plane and air cargo tends to follow the passenger paths to the big hubs, which
may impede the cargo delivery. Further, because of passenger driven networks,
and lack of integrated IT systems, the combination carrier model (for example
the combination and freight forwarder cooperation) is unable to offer the same
efficient door-to-door express deliveries as the integrator which owns its own
sophisticated cargo transport network. Combination carriers have ruefully
examined the success of integrators and have had to meet the challenge by
means of acquisitions, alliances and air agreements. The second study
investigates the economic benefits for combination carriers to develop or
partner with dedicated air cargo networks.
A theoretical model of an air cargo alliance between a combination carrier
and an all-cargo carrier is provided. The alliance effects on partners market
share and profit, and the total social welfare are studied. The results show that
by aligning the passenger-cargo network and dedicated cargo network, the
partners do earn more market share and more profits in both the networks. The
positive synergies can be evaluated in terms of more convenient and consistent
travel time, improved service quality and saved cost. Further, the alliance
would damage a rival firm, which operates in both types of cargo service
networks, by a reduction of the market share and profit. Simulation studies
also investigate the network design effect on the alliance synergies.
The third study develops an intermodal alliance model to investigate the
competition between integrators and forwarders. Integrators have successfully
adopted the strategy of offering superior service at a premium price. They
have become large, well-financed enterprises with very strong networks, and
carry significant amounts of heavyweight freight, particularly internationally.
On the other hand, forwarders offer cargo services only by partnering with
airlines and other cargo service providers. Forwarders, along with their airline
partners, continue to handle about 75% of all international air shipments
(Clancy and Hoppin, 2001). This leads to the development of an analytic
model to determine the success of individual freight forwarder. The model
shows that forwarders rely heavily on the integration with other cargo service
93
providers, especially the airlines. Simulation results are presented to assist
forwarders in choosing their appropriate partners.
In many countries airlines are government-owned - eg Singapore Airlines,
Swissair et al. So governments have a vested interest in the future of their
national airlines and potential mergers. Also, many governments have a
watchdog role to ensure open competition, so mergers and alliances are
scrutinized by government. For example, Air New Zealand and Qantas have
been trying to merge for years, but the NZ Commerce Commission won't
allow it yet tools such as those developed here in the thesis are crucial for
the stakeholders to objectively analyze the benefits of potential mergers and
alliances. Using these tools would allow such organizations to objectively
review such plans at a clinical, rather than subjective level.
This thesis provides simple analyses of the air passenger and cargo
alliance effects, the network structure on the alliance synergy, and the
multimodal logistics competition. Although the models capture in simple ways
nearly all the key elements of airline alliance optimization problems, some
results are limited: the alliance effects on social welfare and consumer surplus
are derived with the assumption that the competition markets are symmetric,
and the simulation results only elaborate the linear market demand case.
Further, the alliance service networks are assumed to be strategic
complements or strategic substitutes. The network structures are fixed when
the partners exhibit a two-stage Cournot Nash equilibrium. This could be
extended in future work where network design factors are introduced.
More research work could be done along the following directions:
The third topic investigates the competition between the forwarder-
airline alliance and the integrator, each of which is viewed as a
multimodal transportation chain in a multi-market air cargo network.
Thus competition is no longer just between individual firms but
between firms and their related transportation chains. With this
framework, while the analysis in the thesis focuses on the airfreight
market, it may also be applied to other transportation markets
94
involving multimodal operations (e.g., between container shipping and
ground transport, or between shipping lines and rail companies, or
between rail and truck carriers) and competition.
Based on the aggregate effect of the airline alliances developed from
the models in the thesis, some organizational research in airline
ownership could be followed
Comprehensive sensitivity analysis is required to develop more rules
for decision making and network design.
95
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Appendix A
Proof for Proposition 4.1.
For the convenience of the proof, we use denote
respectively
3 2 1
, ,
D B A
, ,
34
. Differentiating (4.19) with respect to yields
0 =

+
d
d
d
dQ
(A.1)
where
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(

=
3
66
3
65
3
64
3
63
3
62
3
61
2
56
2
55
2
54
2
53
2
52
2
51
2
46
2
45
2
44
2
43
2
42
2
41
1
36
1
35
1
34
1
33
1
32
1
31
1
26
1
25
1
24
1
23
1
22
1
21
1
16
1
15
1
14
1
13
1
12
1
11
, Q ,
(
(
(
(
(
(
(
(

=
6
5
4
3
2
1
q
q
q
q
q
q
(
(
(
(
(
(
(
(

2
6
3
5
3
4
0
0
0
d
d
.
Note that can be expresses as

34
Note this donation is also made in the following proofs of Propositions 4.2-4.4.

104
] ][ [
1
1
1
1
1
1
] [
3
66
2
55
2
44
1
33
1
22
1
11
3
65
3
64
3
63
3
62
3
61
2
56
2
54
2
53
2
52
2
51
2
46
2
45
2
43
2
42
2
41
1
36
1
35
1
34
1
32
1
31
1
26
1
25
1
24
1
23
1
21
1
16
1
15
1
14
1
13
1
12
3
66
2
55
2
44
1
33
1
22
1
11
R I diag
R R R R R
R R R R R
R R R R R
R R R R R
R R R R R
R R R R R
diag

(
(
(
(
(
(
(
(
(
(
(
(
(
(
(

=
(A.2)
where
= R
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(

0
0
0
0
0
0
3
65
3
64
3
63
3
62
3
61
2
56
2
54
2
53
2
52
2
51
2
46
2
45
2
43
2
42
2
41
1
36
1
35
1
34
1
32
1
31
1
26
1
25
1
24
1
23
1
21
1
16
1
15
1
14
1
13
1
12
R R R R R
R R R R R
R R R R R
R R R R R
R R R R R
R R R R R
and R is the derivative of network is reaction function.
Solving (A.1) for
i
jk
i
jj
i
jk

1
) (
d dQ , we obtain
105
(
(
(
(
(
(
(
(

=

2
6
3
5
3
4
1 3
66
2
55
2
44
1
33
1
22
1
11
1 1
0
0
0
] [ ] [ diag R I
d
d
d
dQ

.
(A.3)
Referring to the second-order condition, we know the diagonal matrix is
negative. Furthermore, by (4.10) and (4.9) we know that , but
. Next we will determine the sign of [ . The stability of the
Cournot-Nash equilibrium implies that the magnitude of the eigenvalues of the
matrix R must be less than unity (Zhang and Zhang, 1996). Hence, by the
Neumann lemma, [ exists and
0
3
4
> 0
2
6
>
0
3
5
=
1
]

R I
1
]

R I
(A.4) | | L L + + + + + =
n
R R R I R I
2 1
By (4.12)-(4.14) and the second-order condition, it can be shown that the
matrix R has the following signs:
(A.5)
(
(
(
(
(
(
(
(

+

+
+

+
=
0 0 0
0 0 0 0 0
0 0 0
0 0 0
0 0 0 0 0
0 0 0
R
Hence, by (A.4), [ must have the following signs:
1
]

R I
[ . (A.6)
(
(
(
(
(
(
(
(

+ +
+
+ +
+ +
+
+ +
=

0 0
0 0 0 0 0
0 0
0 0
0 0 0 0 0
0 0
]
1
R I
106
Then according to (A.2), we have
(
(
(
(
(
(
(
(

+
+

=
0
0
d
dQ
. (A.7)
Q.E.D.
Proof for proposition 4.2.
Substituting the equilibrium quantities ( into (4.19),
and differentiating with respect to
) , , , , ,
6 5 4 3 2 1
q q q q q q
, we have

= =
j
j
j
j
j
j
q
q
q
q d
d
6
4
1 3
1
1 1
. (A.8)
By the first-order conditions, the first part of the right side in the above
equation will be zero. And by (4.11), (4.14) and Proposition 4.1, it is easily
shown that 0
1
< d d .
Similarly,

= =
6
6
2 5
4
2 3
1
2 2
q
q
q
q
q
q d
d
j
j
j
j
j
j
(A.9)

= =
6
6
3 5
4
3 3
1
3 3
q
q
q
q
q
q d
d
j
j
j
j
j
j
. (A.10)
By the first order conditions, and eqns (4.10), (4.11) (4.14), and Proposition
4.1, it can be seen that 0 , 0
3 2
> > d d d d .
Q.E.D.
Proof for Proposition 4.3.
Let the vector of changes in total output on P/C and C network denoted by
107

(
(
(

+
(
(
(

=
(
(
(

+
+
+

6
5
4
3
2
1
6 3
5 2
4 1
~
q
q
q
d
d
q
q
q
d
d
q q
q q
q q
d
d
d
Q

d
(A.11)
Partition the Hessian matrix into
(A.12)
(
(

=
22 21
12 11


where each of
ij
is a 3 x 3 matrix. Then, (A.1) may be written as
0
6
5
4
12
3
2
1
11
=
(
(
(

+
(
(
(

q
q
q
d
d
q
q
q
d
d

, (A.13)
.
3 , 2
6
5
4
22
3
2
1
21

d
d
q
q
q
d
d
q
q
q
d
d
=
(
(
(

+
(
(
(

(A.14)
where
(
(
(

2
6
3
5
3
4
3 , 2
d
d
. Solving (A.13) and (A.14), we obtain

(
(
(

=
(
(
(

6
5
4
1
3 , 2
3
2
1
q
q
q
d
d
R
q
q
q
d
d

(A.15)
where matrix can be interpreted as the derivative of the reaction
function of firm A. To ensure the equilibrium is stable, we should know the
norm of this matrix must be less than unity (Zhang and Zhang, 1996), i.e.,
. It follows that either | or
, since | . Thus, by the result
of Proposition 4.1, we know
12
1
11
1
3 , 2

R
| /
6
d dq
1 || ||
1
3 , 2
< R
| / |
3
d dq
| / | | /
4 1
d dq d dq <
0 | = | < / | | /
5 2
= d dq d dq
108

(
(
(

+
(
(
(

=
(
(
(

+
(
(
(

d dq
d dq
d dq
d dq
q
q
q
d
d
q
q
q
d
d
d
Q d
/
0
/
/
0
/
6
4
3
1
6
5
4
3
2
1
~
(A.16)
must have at least one positive element. That is the total cargo output is
increased in either P/C network or C network. Accordingly, the full price of
cargo service after the alliance must decline in at least one network between
P/C and C.
If under some particular case, for example, the demand is asymmetric
between P/C and C network, and carriers K and L have the same cost function,
we will have dq and . Then the stability condition will
implicate that
3 1
dq =
6 4
dq dq =
0
/
0
/
/
0
/
6
4
3
1
6
5
4
3
2
1
~
>
(
(
(

+
(
(
(

=
(
(
(

+
(
(
(

d dq
d dq
d dq
d dq
q
q
q
d
d
q
q
q
d
d
d
Q d
. (A.17)
Q.E.D.
Proof for Proposition 4.4.
Differentiating (4.26) with respect to and using (4.23), we obtain
( ) | |
( ) | | | |
| |

d
dq
C q g P
d
dq
C P
d
dq
C q g P
d
dq
C q q g P
d
dq
C P
d
dq
C q q g P
d
dW
c
c c
c
6
' 3
* 1
6 ' 3 ' 3 3
5
' 2
2
2
4
' 2
1
4 ' 1 ' 1 2
3
' 1
* 1
3 1 ' 1 ' 1 1
2
' 1
2
1
1
' 1
1
3 1 ' 1 ' 1 1
) ( ) (
) ( ) (
) ( ) (
+ + +
+ + + + +
+ + + =


(A.18)
By the first order conditions, we know each item in the bracket is positive, but
from proposition 4.1, we know the quantity change may be negative or
positive, so the sign of d dW is not clear. But if assuming the symmetric
109
demand and cost functions for P/C network and C network, following
Proposition 4.3, we will know . 0 >
d
dW

Q.E.D.
110
Appendix B
Proof of Proposition 5.1:
Without loss of generality we set 0
1
= and =
2
.
35
Differentiating
equations (5.11) and (5.12) with respect to yields (noting that in (5.11) and
(5.12), Q are substituted with Q ):
i
) , (
2 1

i
(B.1) 0
2 1
12
1 1
11
= +

Q Q
(B.2) 0
2
2
2 2
22
1 2
21
= + +

Q Q
where is a column vector. Solving (B.1) and (B.2) for Q and
, we obtain:
| 1 , 0 , 0
2
2
=

|
1

Q
( ) ( ) | | ( ) ( )
2
2
1
2
22
1
12
1
1
11
1
2
21
1
2
22
1
12
1
1
11
1

=

I Q (B.3)
( ) ( ) | | ( )
2
2
1
2
22
1
1
12
1
1
11
2
21
1
2
22
2

=

I Q (B.4)
where I is the identify matrix. Differentiating ( ) ( ) ( ) 0 , , ,
2 1
2
2 1
1 1
1
Q Q
with respect to Q yields the following 33 derivative matrix of chain 1s
reaction functions:
2

( )
( )
1
12
1
1
11 2
2 1
1
2
=

dQ
Q dR
R
where ( )
2 1
Q R
( )
1
2
22


is chain 1s reaction function with respect to chain 2s outputs.
Similarly, a derivative matrix of chain 2s reaction is given by
. We now show that every element of and matrices
is negative. First, ( , the inverse of the Hessian matrix, can be expressed
as:
2
21
2
1
= R
1
2
R
2
1
R
)
1
1
11

35
Note this simplification is also made in the following proofs of Propositions 5.2-5.4.
111
( )
( )
(
(
(
(
(
(
(
(

1 1 1 1 1 1
1 1
2
1 1 1 1 1
1 1 1 1
2
1 1 1
1
11
1 1 1 1 1 1 1 1 1 1 1 1
1 1 1 1 1 1 1 1 1 1 1 1 1 1
1 1 1 1 1 1 1 1 1 1 1 1 1 1
1
b b a a b c a a b b a c
c b a a c a c c a a c b a c
b b c a c b c a c b c c b b

where subscripts a, b and c represent the AB, BC and AC markets, respectively.
By the second-order conditions and the strategic complementarities (5.13),
every element of ( is negative. Similarly, )
1
1
11

( )
1
2
22

2
1
R
is a negative matrix.
Secondly, and are negative diagonal matrices owing to the strategic-
substitutes condition (5.5). Therefore, both and are negative matrices.
1
12

2
21
1
2
R
By using and , (B.3) and (B.4) can be rewritten as:
1
2
R
2
1
R
| | ( )
2
2
1
2
22
1
2
1
2
1
1
2
1

=

R R R I Q (B.5)
| | ( )
2
2
1
2
22
1
1
2
2
1
2

=

R R I Q (B.6)
The stability of Cournot-Nash equilibrium implies that the magnitude of the
eigenvalues of matrices R and must be less than one (Zhang and
Zhang, 1996). Hence, by the Neumann lemma,
2
1
1
2
R
1
2
2
1
R R
( )
1
2
1
1
2

R R I exists and
( ) ( ) ( ) ( ) L L + + + + + =
n
R R R R R R I R R I
2
1
1
2
2
2
1
1
2
2
1
1
2
1
2
1
1
2

Since is a positive matrix,
2
1
1
2
R R ( )
1
2
1
1
2

R R I is also a positive matrix.
Similarly, ( )
1
1
2
2
1

R R I
1
2
R
is a positive matrix. It follows that Q and Q
since is a negative matrix and is a negative vector.
Q.E.D.
0
1
>

0
2
<

2
2
Proof of Proposition 5.2:
Substituting into chain 1s profit function and differentiating
the resulting profit with respect to
(
2 1
,
i
Q )
yields:
112

AC BC AB k Q
Q
Q
d Q Q
k
k
k
k
k
, , ,
1
2
2
1 2
1
2
1
1
1
1
=

(B.7)
where by the first-order condition (5.11). By condition (5.4) and
Proposition 5.1,
0
1
1
=
0
1
> .
Similarly, substituting ( )
2 1
,
i
Q into chain 2s profit function and
differentiating the resulting profit with respect to yields:
( ) . , , ,
'
2
2 2
1
1
2 2
AC BC AB k g Q Q
Q
Q
d
AC k
k
k
k
k
=

(B.8)
In (B.8), the summation term is negative by (5.4) and Proposition 5.1. Thus, if
, which is positive (the increase in integration costs), is not too big,
then
( )
'
2
g
0
2
< .
Q.E.D.
Proof of Proposition 5.3:
Let Q be the total output vector and ( ) Q be the corresponding full price
vector. Then,

2 1

Q Q
Q
+ =

Q

. (B.9)
Rearranging (B.1) and using ( )
1
12
1
1
11
1
2
=

R , we have:

Q = . (B.10)
2 1
2
1

Q R
Substituting (B.6) and (B.10) into (B.9) yields:
( )( ) ( )
2
2
1
2
22
1
1
2
2
1
1
2
+

R R I R I

= Q (B.11)
By using the symmetric condition and ( )
2
21
1
2
22
2
1
=

R , (A1.11) can be
rewritten as:
113
( ) | | ( )
2
2
1
2
22
1
2
21
1
2
22 0
|

+ =

=
I Q (B.12)
(B.12) can be further simplified, by using the result ( )
1 1 1
= A B AB , as:
( )
2
2
1
2
21
2
22 0
|

+ =

=
Q (B.13)
Since both and matrices are negative definite, is a
negative definite matrix. Its inverse matrix,
2
22
2
21

2
21
2
22
+
( )
1
2
21
2
22

+ can be expressed as:
( )( ) ( ) (
( )( ) ( ) ( )
( ) ( ) ( )(
(
(
(
(
(
(
(
(

+ + + +
+ + +
+ + +
+
2 2 2 2 2 2 2 2 2 2
2 2 2
2
2 2 2 2 2 2 2
2 2 2 2 2
2
2 2 2 2 2
2
21
2
22
1 2 2 2 1 2 2 2 1 2 2 2 2 2 1 2 2 2 2 2
1 2 2 2 2 2 2 2 1 2 2 2 1 2 2 2 2 2 2 2
1 2 2 2 2 2 2 2 2 2 2 2 1 2 2 2 1 2 2 2
, ,
, ,
, ,
.
1
b b b b a a a a a a a a b c b b b b a c
a a a a c b c a c c c c a a a a c b a c
b b b b c a b c c a c b c c c c b b b b
)
)

where subscripts a, b, and c represent the AB, BC and AC markets, respectively.
Since every element of ( )
1
2
21
2
22

+ is strictly negative, the inverse matrix is
a negative matrix. Combining with vector implies . Therefore
2
2
0 |
0
<
=
Q
( ) 0 |
0
>
=
d Q d .
Q.E.D.
Proof of Proposition 5.4:
Differentiating (5.17) with respect to and using
i
k
i
k k
Q U = yields:

( ) ( )
( )

'
2
2
2
2
1
' '
2
1 ,
'
g
Q
Q
Q
C C P
Q
C P
d
dW
AC
AC
i
AC
i
i
BC
i
AB
i
AC
i
k
i BC AB k
i
k
i
k

|
|
.
|

\
|

=

= = =
(B.14)
Under the symmetric case and 0 = , (B.14) is reduced to:
114

( )
( ) ( ) 0
|
'
2
2
2 1
'
1
'
1 1
2 1
,
'
1 1
0
g Q
Q Q
C C P
Q Q
C P
d
dW
AC
AC AC
BC AB AC
k k
BC AB k
k k

|
|
.
|

\
|

+
|
|
.
|

\
|

=

=
=




By the first-order conditions and Proposition 5.3, 0 < d dW when evaluated
at 0 = (assuming is small).
Q.E.D.
( ) 0
'
2
g
Solutions of Cargo Quantities in Connecting Market:
Y X Q
AC
/
1
= and , with Y Z Q
AC
/
2
=
| |
( ) ( ) | |
( ) | |
( ) | |
( ) | | ) 4 14 4 ( 9 3 ) 3 4 )( 2 ( ) 1 (
) 4 14 4 ( 9 3 ) 3 4 )( 2 ( ) 1 (
) 7 7 3 8 6 ( 3
) 2 5 ( ) 3 ( 5 ) 3 ( 3 ) 6 3 ( 5 3
) 3 ( 5 ) 5 ( 8 ) 7 ( 3 ) 3 6 ( 46 24 34
) 3 7 ( 3 ) 3 5 ( 34
2 2
2
BC BC BC AB BC BC AB AB
AB AB AB BC AB AB BC BC
BC AB AC
AB AB AC BC BC
AB AB AC AB AB BC
AB AB AC AB AB
X






+ + + + +
+ + + + +
+ + + +
+ + + + + + + +
+ + + + + + +
+ + + =

(B.15)


(B.16)
( )
( ) | |
BC BC AB
BC BC BC AB
BC BC BC BC
Y



) 2 6 15 ( 14 3 48 10 27 2
) 6 9 4 12 30 ( 4 6 18
) 2 3 9 10 27 ( 2 ) 4 9 ( 3
2 2 2
2 2 2
2 2 2
+ + + + + +
+ + + +
+ + + =


115
( ) ( ) | |
( ) | |
( ) | |
| | ) 2 3 8 ( 3 6 ( ) 2 4 3 ( ) 1 (
) 2 3 8 ( 3 6 ) 2 4 3 ( ) 1 (
) 2 4 ( 3 6 6
) 4 ( ) 2 ( 8 7 12 ) 3 24 ( 4 4 21 2
) 3 6 (
) 7 12 8 8 42 ( ) 6 9 ( 12 12 36
2 2
2 2
2 2 2 2
2 2 2 2 2
2 2 2
2 2 2 2
BC BC BC AB BC BC BC AB AB
AB AB AB BC AB AB AB BC BC
AB AB AB AC AB BC
AB AB AC AB AB BC
AB AC AC
AB AC AC AC
Z






+ + + + + + +
+ + + + + + +
+ + + + + +
+ + + + + + + + +
+ +
+ + + + + + =

(B.17)
P
M
Q
a
AC
=
1
and
P
N
a
AC
=
2
Q , where

( ) | |
( ) ) 16 ( 12 12 9
) ( ) 1 ( 3 ) 1 ( 3 18 ) 1 )( 1 ( 2
+ + +
+ + + + + =
BC AB BC AB AB BC AC
BC BC AB AB AB BC BC BC AB
M


(B.18)

( ) | |
( ) ( | | 9 ) 3 ( 5 21 ) 3 8 ( 5 ) 7 3 ( 3 9
) ( ) 1 ( 3 ) 1 ( 3 18 ) 1 )( 1 (
2
+ + + + +
+
)
+ + + + =
BC BC AB BC BC AB BC BC AC
BC BC AB AB AB BC BC BC AB
N



(B.19)

( ) ( ) | | ) 16 5 ( 9 2 ) 10 3 ( 6 ) 3 ( 6 9 3
2
+ + + + =
BC BC AB BC BC AB BC BC
P
(B.20)


116