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CLEMSON / Economics / ECON 2110 / How do you allocate resources in economics?

How do you allocate resources in economics?

How do you allocate resources in economics?


School: Clemson University
Department: Economics
Course: Principles of Microeconomics
Professor: Fiore
Term: Winter 2016
Tags: Microeconomics, professor fiore, fiore, final, Econ, and econ211
Cost: 50
Description: content from tests 1-3 and all content covered after that.
Uploaded: 04/28/2016
19 Pages 214 Views 4 Unlocks


How do you allocate resources in economics?




Scarcity- constantly facing choices because of scarce time

Crucial question: “how should scarce resources and goods be allocated?” Suppose lots of people move to G-vegas…

- Should houses stores or roads be built?

- Who tells everyone to do these things? THE MARKET! ( free market set-up)  not the gov’t  

Economics provides a model of how resources are allocated (how people make  these choices)

1. They optimize choosing the best option to meet their objectives 2. EQUILLIBRUIM results


- MICO- studies CHOICE and its implications for price and quality in individual  markets

- MACRO- studies the performance of national economics and the policies that  GOV’TS use to try and improve that performance  

How would you decide on your objectives?

Don't forget about the age old question of Who is the pope from the middle ages?

Economic model is based on several fundamental principals  

1. INCENTIVES MATTER- they’re everywhere!

a. Ex. 1787: british gov’t hired sea captains to transport prisoners to  austrailia; pay determined by # transported dead or alive. Most dead.  b. Adam smith “They’re not doing it for you, it is for tier own gain” ie to  make a living

c. People respond to incentives in predictable ways Don't forget about the age old question of Where does zora neale hurston grow up?

d. Seatbetls: seatbelts invented and installed; crashes went up; “driving  faster is safer!” resilt: more accidents, fewer driver deaths; more  pedestrian deaths. Overall death toll remained the same. Do safer cars make NASCAR drivers drove more recklessly? YES 3.6% more

e. Birth control: unwanted pregnancies: reduces the “price”/risk of sex =  more sex, rates pretty much unaffected  

What are the choices that economist study?


a. When self-interest aligns w/ public interest, we get good outcomes;  markets channel self-interest of millions; can be done under right  conditions  

b. Markets DO NOT ALWAYS align self interest with social

i. Incentives are too strong, eternal cost; pollution

ii. Incentives are too weak, external benefits; flu shots


a. What started the revolution in food processing that made these extra  calories cheaper? We also discuss several other topics like What happens to the cone of depression if pumping increases?

b. Labor force participation rate of women doubled between 1960 and  2000

c. Thus, the opportunity cost of women’s time has been rising, increasing  the demand for easy to prepare food

d. The food industry responded, just as economic analysis would predict. e. What would you expect to happen to college enrollment during a  recession?

i. Opportunity cost of going to college= wage you coud have been  earning

ii. Tuition / books = opportunity cost when paid for  

iii. Prediction: college enrollment up, unemployment up

f. Why have Americans gained weight starting in the 60’s?

i. Move from active to sedentary jobs

ii. Less active lifestyles

iii. Higher caloric intake due to the way food is prepared  

iv. Why are extra calories cheaper? Women joined workforce  men  incompetent and wont cook themselves a meal  opportunity  cost of home meals up so demand for easy to prepare food up  food industry responds now we’re all fat.  


a. Is sleep or studying ore important? ( hard to answer, bad question) b. Is one more hour of studying tonight more important than one more  hour of sleep? 7 pm yes 1 am no

c. Marginal=additional

d. Making choices by comparing the EXTRA benefit to EXTRA cost of an  action. That is, compare the MARGINAL BENEFITS to the MARGINAL  COSTS Don't forget about the age old question of What is considered drastic weight loss?

e. What are some marginal costs of going to the Clemson basketball  game in virgina?

i. Gas, tickets hotel room, time stidying

f. MARGINAL COST AND OPPORTUNITY COST ARE THE SAME g. Every decision involves both benefits and costs at the margin h. Marginal principal is:

i. Marginal benefits > marginal costs, DO IT

ii. Economics assumes people are rational.

i. Can flying be “too safe?”

i. Safety confers benefits (live longer) but achieving It entails cost  (must give something up, seats, raise price, etc)  

ii. As safety rises, marginal benefits of additional safety decline

iii. Amount of safety increases, both total and marginal costs  

providing safety rises

iv. How much safety should we have (If MB > MC, do it)

v. Can flying be too safe? (if MB < MC, yes)

vi. ** badly worded question. At one point safety is so high that its  not worth throwing more money at because the chance of  

anything happening is so low; wasted money that could go  Don't forget about the age old question of What is the weapon focus effect?

somewhere else

**** “death by bureaucrat” reading****

Type I error: reject idea when it is true (case of meds, lives that could have been  saved don’t live)

Type II error: accept idea when it is false (case of meds, putting out a drug that will  kill)

**** we’re too cautious and it hurts more than help****


a. Both people involved in voluntary exchange are better of ( in  expectation)

b. Ex: I sell a student football ticket and sell it for $200. We both win!  Buyer valuses the game at least $200, I value the game less than $200 c. “the power of trade” it increases production through specialization



TEST 1- the economic model

- Scarcity- constantly facing choices because of scarce time (driving  force of economics)  

- Economics provides a model of how recourses are allocate and how  people make these choices

o Optimize choosing the best option to meet their objectives o EQUILLIBRIUM results


o MICRO-studies CHOICE and its implications

o MACRO- studies the performance of national economics and  policies that GOVERNMENTS use

- THE ECONOMINC MODEL Don't forget about the age old question of What is the human diaspora?

1. Incentives matter

2. Good institutions align self-interest with social interest  

3. Trade-offs are everywhere  

4. Rational people make choices at the margin

5. Trade makes people better off  

CHAPTER 2- marginal decisions  



Total benefit



Total cost

Marginal cost


























- Total benefit = total enjoyment of the item (valued in $ for sake of  value and problem)

- Marginal benefit = how much MORE benefit you get from buying one  more compared to before

- Total cost = cost of x amount of y  

- Marginal cost = how much MORE another slice will cost

o ** MARGINAL = how much MORE compared to price before - Positive statement – addresses the consequences of an action o “if the price of potato chips falls, people will eat more potato  chips”

o Solid fact

- Normative statement – expresses a value judgement

o “people eat too many potato chips”

o Opinion  


o Comparative advantage- specializing based on differing  opportunity costs

o Gains in trade because people have different preferences and  value things differently.

o Trade allows for specialization which reduces opportunity costs - Comparative advantage – to specialize in an activity in which you have  the LOWER opportunity cost

- Absolute advantage- can produce a good using fewer resources  

CHAPTER 3- supply and demand

- Demand and supply are based on OPTOMIZING behavior by individual  decision makers and put the 2 together and we find the EQUILIBRUIM  - DEMAND

o How much is a good valued?

 Depends on marginal benefits the consumer gets from  

consuming the good

 Demand is measure of this value

o Measuring demand is the relationship between PRICE and  QUANTITY


o Demand is thus: a list of quantities corresponding to specific prices o Demand schedule, demand curve, equation is: Q(quantity)=10-P(price) **always expressed as quantity demand being a function of price (ie Q  on the left side)


o The relationship between PRICE and QUANTITY along a demand curve  is ALWAYS NEGATIVE!!!


o Producers will only be willing to supply a good if they can receive more  than their opportunity cost (marginal cost)

- Quantity supplied vs supply

o Quantity supplied: the quantity that sellers are willing and able to sell  at a given price

o Supply- a function that shows the quality supplied at different prices - Why do supply curves slope upwards? Why are higher prices necessary to get bigger quantities supplied?

CHAPTER 4 – putting demand and supply together

- Any given time in an ACTUAL MARKET we only see ONE price when  quantity demanded and quantity supplied are equal (EQUALLIBRUIM  PRICE)

- Suppose price is greater than equilibrium price

o Excess supply  

o Price will fall

o As the price falls, 2 things happen:

 Qdemand rises (buyers want to purchase more at lower prices)  Qsupply falls (sellers are willing to sell less at lower prices)

 Price will fall until (Qdemand=Qsupply)

- Suppose price is less than equilibrium  

o Excess demand

o Price raised

 Qdemand falls (buyers want to purchase less at a higher price)  Qsupply rises (sellers are willing to sell more at higher prices)  Price will rise until (Qdemand=Qsupply)


o So neither P>P* nor P<P* can persist in freely operating markets - Illustrating changes in demand (slopes down)

o An increase in demand  shift to the right  

o A decrease in demand  shift to the left

- Illustrating changes in supply (slopes up)

o An increase in supply  shift to the right  

o A decrease in demand  shift to the left  

- Impact of demand changes on equilibrium price and quantity o Demand decreases: price goes down, quantity goes down

o Supply increases: price down, quantity up

o Supply decreases: price up, quantity down

- Factors that shift demand





- Factors that shift supply




CHAPTER 5 – own price elasticity

- PRICE ELASTICITY- a measure of responsiveness of quantity to changes in  price

- Measuring elasticity in demand:

o % change in Quantity demanded for a given % or change in price - Measuring elasticity in supply:

o %change in quanitity supplies for given % change in price

- Each measures how quickly quantity changes as one mores up or down the  curve on the graph (demand or supply)


o Law of demand says “prices go up  quantity down, vice versa” o Elastic demand- relatively large quantity change when price changes  If demand is elastic, even a small price increase will be enough  to inspire many buyers to stop buying

o Inelastic demand- relatively small quantity change when price changes  If demand is inelastic, many buyers will go on buying even in the face of a large price increase

o Demand is elastic if Ed > 1 (ie numerator >denominator)

 %change in Qd > % change in P

 Consumers are “price sensitive”

o Demand is inelastic if Ed< 1 (ie numerator < denominator)

 %change in Qd < % change in P

 Consumers are NOT price sensitive  

o Demand is unit elastic if Ed = 1



- Elasticity and slope are different

- As price rises, demand becomes ore ELASTIC

- BUT AT THE SAME PRICE, Aa steeper slope generally signifies LESS ELASTIC  demand  

- TOTAL REVANUE = price x quantity (TR = P x Q)

- If demand for your product is elastic…

o You should drop your price (ex have a sale) to increase your total  revenue  

o Raising price will decrease your total revenue

- If demand for your product is inelastic…

o You can raise your price without losing a bunch of buyers; thus  increasing your total revenue

o Raising price will increase your total value  

- The law of demand says “price up  quantity down, vice versa” - But by how much does quantity demanded fall or rise?

- Ex: two different supply curves for the same market…

- Equations:

o Elasticity of supply: Es = (% change in Qs)/(% change in P)

o Supply is ELASTIC if Es >1

o Supply is INEALSTIC if Es<1

o Supply is UNIT ELASTIC if Es=1

o Note: elasticity of supply is ALWAYS POSITIVE

o Law of supply positive relationship

Perfectly elastic supply

- If supply is perfectly elastic, Es=infinity

- This would imply that quantity supplied can be expanded without raising per  unit costs

- What must the supply curve look like? (straight horizontal line)

Perfect inelastic supply

- If supply is perfectly inelastic, Es=0

- This would imply that there are no increase in quantity supplied regarless of  the size of the increase price

- What must the supply curve look like? (straight vertical line) -



Total revenue = price x quantity (TR = P x Q)

Products with a lot of good substitutes and an elastic demand often offer coupons;  drop in price will lead to revenue  

For expensive last minute plane tickets: demand a month in advance is relatively  elastic, while demand 3 days before is relatively inelastic  

If demand for your product is elastic, you should drop your price (sale) to  increase total revenue; raising price will decrease your total revenue  

If demand for your product is inelastic, you can raise price without losing  buyers, increasing price increasing your total revenue  


- Law of demand says “price up  quantity down, vice versa” - supply curves reflect COST

- Equations:

o Elasticity of supply: Es = (% change in Qs)/(% change in P)

o Supply is ELASTIC if Es >1

o Supply is INEALSTIC if Es<1

o Supply is UNIT ELASTIC if Es=1

o Note: elasticity of supply is ALWAYS POSITIVE

o Law of supply positive relationship


- Perfect elastic supply is Es = infinity; straight horizontal line

o Q supplied can be expanded w/o raising per unit costs

- Perfect inelastic supply is Es = 0; straight vertical line

o No increase in Q supplied regardless of the size of increase of price  

CHAPTER 7: MARKET EFFICIENCY (skim ch 3, 4, 7)

- We evaluate actions “at the margin”’

- The most efficient action is the one that produces the biggest net gain  (biggest positive difference between MB and MC)

Social welfare consequences on markets


- Trade and specialization are big reasons why we’re so much better off today  than the past

- The gains from trade are measured of how much better off the operation of a  market makes us  

- Simple ex:

o John would get $25 in benefits from a widget, but doesn’t have one o Sarah has a widget, and an opportunity cost of letting it go of $10 o If the widget moves from Sarah to John, the values rises from 10 to 25 - If the trade occurs, society is $15 better off

Gains form trade and markets?

- Assume trade occurs at the equilibrium price. How large are the gains to  society?

o The demand curve indicates the benefits enjoyed by consumers o Supply curve indicates the costs to producers of supplying the good  o Trade occurs where the benefit to consumers is greater than the cost  to producers

o The area (triangle) represents the total gains from trade generated in  that market

o The gains from trade are also known as the “TOTAL SURPLUS” Who gets the surplus?

- Some of the surplus is enjoyed by consumers and some is enjoyed by  producers

o The market price is the consumers opportunity cost (what they must  give up to obtain a unit of the product)

 Thus: the area between demand curve and the market price  indicates how much better of consumers are bc they can trade  in this market


o The market price is also the benefit that suppliers receive for selling  their product

 This the area between the market price and the supply curve  indicates ow much better off producer are bc they can trade in  this market  

 This is called PRODUCER SURPLUS (CS)

o The sum of the two is the TOTAL SURPLUS generated in that market  


- Gains from trade are a measure of how much better off the operation or  markets make us  

Gov’t intervention in markets

- Price controls (price ceilings, price floors)

- Taxes

- Subsidies  

Price ceiling- legislated maximum price  

- Rent controls, gas in 70’s, goods in disasters

- If a price is clearly “unreasonable and affordable and equilibrium, price ceiling is set below equilibrium

- Problem: consumers DO buy more X at lower price and Qd rises - Problem: suppiers DO supply fewer X at lower price and Qs falls - Ceiling set ABOVE eq. does NOTHING  

Price floor- legislated minimum price

- Agricultural products (milk) so little farmers can compete

- Price floors create surplus, loss in gains from trade, wasteful increase in  quality, misallocation of resources

- Price floor must be set ABOVE eq. price to be BINDING

o Ex: minimum wage:

 Higher wages, more job seekers (Q*  Qs)

 Higher wages, fewer job offers (Q*  Qd)

 Creates a surplus of workers (Qs – Qd)

 What workers are most affected by minimum wage? Low skilled  labor!

- Price controls- bottom line

o Price controls reduce gains from trade, making society worse off o Although a lucky few may be able to buy or sell at the controlled  prices, the controls lead to a lot of inefficiencies!

 Shortages

 Surpluses

 Black markets

 Long lines

 Lower quality goods

o Don’t mess with prices!  

 Prices signal important info about benefits and costs. Price  

controls prevent them from doing so

o Ex: rent controls

 Regulation to keep rets from rising to equilibrium prices

 Creates shortages

 Gets worse over time  


Emphasize the following:

1. Who ultimately pays the tax is NOT dependent on who writes the check a. Easy to see with algebra…  

i. Tax on consumers: Pd = Ps + t

ii. Tax on producers: Pd – t =Ps

iii. They are the same!

2. Who ultimately pays the tax does depend on the relative elasticities of supply and demand

3. Taxation raises gov’t revenue but creates lost gains from trade (deadweight  loss)

The burden of tax depends on elasticities of demand and supply

- demand is more elastic than supply (demand is less steep than supply) o consumers pay: Pd  

o producers receive: Ps

o result: most of the tax is paid by the SELLERS

- supply is more elastic than demand (supply is less steep than demand) o result: most of the tax is paid by the BUYERS

- Ex: who pays the cigarette tax?

o Producers can easily avoid tax (state tax)

 Sell in different state

 Sell overseas

 Stop selling

o Consumers are addicted

o Conclusion: supply is more elastic than demand

Tax revenue and lost gains from trade

- Pd, Ps, deadweight loss make a square that is the tax revenue  - Tax revenue = t x Qtax

- Relatively elastic demand and supply vs relatively inelastic demand and  supply

- If your goal is to raise tax revenue, you want to tax something INELASTICALLY supplied AND demanded  

o Ex: tax on yachts  

 Seems like a good way to tax the rich…

 Turns out demand for yachts is very elastic (we’ll just buy  

something else!)

 Hurts the yacht makers


o Ex: income tax vs consumption (sales) tax

 How much productive labor do we lose because of income tax?  This is why many argue for a consumption tax

 Most don’t like consumption tax bc a consumption tax because it is not progressive (doesn’t tax the rich more)


- A subsidy is a “reverse tax”

- Suppose the govt gives a subsidy of size “s” to consumers for every unit  bought

- Demand will increase

- Subsidy is paid for by the tax payers

- Results in inefficient increases in trade

- Gov’t tool to increase activity

CHAPTER 10: EXTERNALITITES (go watch vid link at top of study guide)


What if some are external to the decision maker? = EXTERNALITY; example of  MARKET FAILURE

 fails to maximize total gains from trade

- the river ( a story)

o meat packing plant located on a river; a rater enjoys rafting down the  river

 while packing eat the plant drops wastes into the river

 this garbage lowers the enjoyment for the rafter

o because some of the costs aren’t being counted, too much of the good  is produced

 Qmarket > Qefficient  

- NEGATIVE EXTERNALITY: the “doer” does not bear the full cost of the  action

o There is a COST that is external to the doer’s decision making, so that  the doer doesn’t take it into account

o because some of the costs aren’t being counted, TOO MUCH of the  good is produced

 Qmarket > Qefficient  

Dealing with externalities: standard approach

- Two most common policy responses

1. Quality reg

2. Taxation/subsidies

3. Either has to potential to induce the efficient level of output

- Policy responses to negative externalites:

o Q regulation: ban on texting while driving

o Taxation: tax on alcohol  

- : the “doer” does ot receive the full benefit of the action

o There is a BENEFIT that is external to the doers decision making, so  that the doer doesn’t take it into account

o Bc soe of the benefits aren’t being counted, TOO LITTLE of the good is  produced

 Qmarket < Qefficient  

- When there are externalities, the market outcome will be inefficient (there  will be deadweight loss)

Public goods and common resources

- Extenalities are a particular problem with goods that you can’t stop others  from using  

o Non- excludable goods

- PUBLIC GOOD: a non-excludable good for which one person’s use does not  reduce the amount left for another  

o Ex: plowing snow off the neighborhood roads

 Values of the public: $5000 per person

 Cost to do: $2000 per person

o Is it efficient to plow the roads?

 Yes! (MB>MC)

o But how do we fund it?

 What about people who refuse to pay?

 FREE RIDER: a person who receives the benefit of a good without paying for it

∙ When the cost of excluding free-riders is very high, less  

than the efficient quantity will be produced (POSITIVE  


- COMMON RESOURCE: a non-excludable good for which one person’s use  leaves that much less for everyone else

o Examples:  

 Great plain bison

 Deep sea fishing

 Global warming

o Since no one takes into account the effect of their use on what’s left for others, more than the efficient amount will be done (NEGATIVE  EXTERNALITY)

o When goods are non-excludable, they will probably NOT be used  efficiently  

o Tragedy of the commons  

o Failure to define property rights

 Great plain bison vs cows

 Sea fishing vs. fish farms


Firm Behavior and Market Power  

ch 11 and 13


- If a firm has MARKET POWER, it is able to raise price above the equilibrium  price without losing all of its customers

- How much can market power a seller has depends on the closeness of  substitutes  

o When subs are very close (demand is elastic), a seller loses many  customers if it attempts to raise price  

o When subs are NOT very close (demand inelastic) a seller loses  relatively few customers if it attempts to raise price  

- Recall equilibrium outcome

- For a market to operate exactly at the equilibrium price and quantity, sellers  must be producing PERFECT SUBS  

o Competition among sellers forces price to the equilibrium level  - Es: apple farmers

o World market for red apples vs demand for one farmers red apples - This is known as a PERFECTLY COMPETITIVE market

o Such markets are often reasonable approx. but not necessarily realistic o In many markets, relatively few sellers produce imperfect subs  Coke and pepsi

 Iphone and droid

o In markets where subs are not perfect, firms have market power DIFFERENT LEVELS OF COMPETITION  

- Perfect competition: many sellers with no market power

- Oligopoly: few sellers with some market power

- Monopoly: one seller with market power

- Ch 11 --> pg 193-196

- Ch 13

- How do firms with market power choose the best price?

o Suppose a firm (monopolist) with a market power raises price? o Two things happen:

 It sells fewer units (not good for firm)

 It gets a higher price for each unit it sells (good for firm)

o Thus, even a monopolists is constrained in its ability to raise price by  the downward-sloping demand curve for its product

o A firms goal is not to charge the highest price, but to make the highest  profit  

 Profit = total revenue – total cost  

o A firm will only change price if the change in revenue is greater than  the change in cost

 If marginal revenue is greater than marginal cost, DO IT

o The profit max price is where the marginal revenue equals marginal  cost  

- Ex: onopolist facing a demand of Q0 = 10 – P


- The less elastic the demand a firm faces, the more market power it has… the  more market power a firm has, the larger the markup  

- (((( more graphs))))


- It has no choice!

- Firms facing perfectly elastic demand must accept the market price or sell  none at all

- These firms are called “Price Takers”


- When price is raise above eq. price, total gains from trade are reduced! - The fact that some surplus is redistributed from consumer to producer has no efficient implications

o Of course consumers prefer more surplus  


- The answer depends on the source of market power

o Patent

o Better product

o Cartel

o Government regulation restricting entry  

- Firms can increase their market bower by reducing the relative attractiveness of substitute products

o By “differentiating” its product, making its demand LESS ELASTIC  - How does this affect consumers?

o If the firm does this by producing a “better” product, consumers are  better off

o If the firm does this by reducing competition and consumer choice,  consumers are worse off (ex. Cartel)


- Consider a copyright or a patent  

o Each is a lawful grant of temporary monopoly power (market power) - If monopolies produce deadweight losses, why grant a patent? o Profits provide an important incentive for innovation and improvement  o The static (at this moment in time) effect is to create a DWL

o The dynamic (over time) effect is to inspire innovation

- Our legal system is set up to balance these two effects


- The prospect of high profits inspre firms to act to capture them. - Profits act like a magnet, attracting ENTRY to the high profit sector o Profits include competition that results in valuable goods and services o If the goods/services are not valuable, profits will not result

o For that reason, we don’t need to worry that profits are “too high” as  they will not last long.

- The prospect of higher profits also inspires firms to attempt to restrict  competiton

- If high profits persist, we now that either

o There is something we are not accounting for (e.g. risk)

o Something is preventing entry (e.g. regulation, cartel)

Price Discrimination

- Firms and consumers do not like deadweight loss

- When it charges a SINGLE price, if it cuts that price to sell to additional  consumers, it must cut the price for EVERYONE

- But what if it could charge lower price to those more price sensitive  customers without lowering price for everyone else, i.e. charging lower price  for consumers with more elastic demand and higher for those with less  elastic demand? This is PRICE DISCRIMINATION

- Examples of markets with price discrimination

o Air travel: business vs leisure travel

o Restaurants/bars: senior discounts/happy hour

o Movie theaters: student/senior discounts

- Seller has to limit ARBITRAGE: buying low in one market and selling high in  another market

Game Theory ch 15 and 16

- STRATEGIC INTERACTION occurs when your best action depends on other’s  actions. Likewise your rivals or partners best actions depend on your action. - Implies interdependence in decision making.

- The tool to analyze strategic interaction is game theory


o Two or more players (firms)

o A payoff the players seek to maximize (profits)

o Each player is aware that the actions of the other players can effect  payoffs its payoff, and that their actions can affect the payoffs of the  other players

- Simultaneous move game

o The other doesn’t know what their rival will do, and their decisions are  made simultaneously and they both must deal with the consequences  - Prisoners dilemma

o Whenever each player has an incentive to deviate from the “best”  outcome

o Ex: arms races, advertising, hiring expert witnesses  

- Nash Equillibrium: the result of all players playing their best strategy GIVEN  what their competitors are doing, i.e., no one has incentive to deviate! - Dynamic games

o So far all games have been STATIC meaning all moves made  simultaneously

o In reality moves are often not simultaneous

o Adding DYNAMICS can make the game richer

 Play unfolds over time

 Players can react to prior moves

 Predicting rivals action still crucial

o Predicting your rivals actions will be done using BACKWARD  INDUCTION

 Backward induction means to look at the end of the game and  work your way back


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