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Market Structures 1 Market Structures Market structure refers to the competitive environment in which buyers and sellers of a product operate. Major Types- • Perfect competition • Monopoly • Monopolistic competition • Oligopoly 2 Perfect Competition • Large number of undifferentiated buyers and sellers • Each one is so small as to be insignificant to influence the market • The seller is a price-taker • Homogeneous products • No barriers to entry and exit- survival of the fittest 3 Perfect Competition • Well organised and continuous markets • Flexible market prices to keep responding to changing conditions of supply and demand • Perfect Knowledge on market condition, product and present and future prices, costs and economic opportunities- eliminates price differences 4 Perfect Competition • Perfect mobility of factors of production (raw materials, labour and capital)-this results in factor price equalisation. • No Government interference: No rationing, administered prices, subsidies etc. 5 Perfect Competition Presumption that free market operates in social interest- • “Invisible hand” and self-regulatory mechanism • Provides an effective check on the power of the sellers, safeguards consumer and makes it unnecessary for the State to intervene • Stock market is the closest example of a perfectly competitive market 6 Equilibrium Under Perfect Competition Note: Equilibrium is at the point of intersection between MC and MR MC cuts AC from below at its lowest point Firm may make profits, losses or break even in the short run- depends on its cost of production If firm makes abnormal profit, more firms will enter- Increase in supply- lower price and profit Opposite in case of losses 7 Firm Making Profit in Short Run P=AR=MR as Y represented by the MC horizontal line OP and OQ are AC equilibrium price and E output. P AR=MR OPEQ represents Total A C Revenue OACQ is total cost. O X Here, TR>TC Q O Output u PECA is the short run t supernormal profit. p u t 8 Firm Breaking Even in Short Run MC Firm breaks even Cost/Revenue where AC curve is tangent to AR. TR AC and TC are the same and given by rectangle OPEQ. AR=MR There is neither P loss, nor profit E O Q Output 9 Firm Making Loss in Short Run Total Revenue=OPEQ MC AC Total Cost=OBCQ C Loss= BCEP B P AR=MR E OO Q Output 10 Case of Exit or Shut Down Point • If prevailing market price is more than average variable cost (AVC) of production, the firm will continue production. • If prevailing market price is less than average variable cost (AVC) of production, the competitive firm will shut down production 11 Firm Making Loss in Short Run MC SAC Total Revenue=OPEQ B A TVC= OKLQ SAVC L TR < TC at price OP K TFC= LKAB (Lost P AR=MR entirely) E Operating Loss= OKLQ-OPEQ = PKLE At OP price, firm decides to shut down. OO Q Output 12 Perfect Competition Key lessons of perfect competition for managers • Important to enter the market as far ahead of the competitors as possible - when supply is low and price is high- this requires entrepreneurial skill • A firm earning an economic profit (as distinguished from normal profits) can not afford to be complacent because economic profit will attract new entrants • Only way for a firm to survive is to keep costs as low as possible 13 Perfect Competition • With growing globalisation, new competitive cost pressures are being felt by firms around the world • Indian companies have the advantage of low –cost labour but disadvantage of technology lag • (Obama on outsourcing) 14 Global Competitiveness Index Market Distortions – Efficiency of legal framework – Extent and effect of taxation – Number of procedures required to start a business – Time required to start a business 15 Global Competitiveness Index Competition Intensity of local competition Effectiveness of antitrust policy Imports Prevalence of trade barriers Foreign ownership restrictions 16 QUIZ • Elasticity of demand for a perfectly competitive firm is equal to _____. • Free entry and exit of firms is responsible for ________ _____ in the long run. • A perfectly competitive firm has all the following features EXCEPT: a) Price Taker b) Quantity adjuster C) Perfectly informed d) Price discriminator 17 • Elasticity of demand for a perfectly competitive firm is equal to infinity • Free entry and exit of firms is responsible for normal profits in the long run • A perfectly competitive firm has all the following features EXCEPT: a) Price Taker b) Quantity adjuster C) Perfectly informed d) Price discriminator 18 QUIZ • In a perfectly competitive market, a firm in the long run operates at: A) AC=MC B) AR=MR C)MR=MC D) P=AR=MR=AC=MC 19 QUIZ TRUE OR FALSE? • The government sets the price of the product in a perfectly competitive market. • A perfectly competitive firm produces a substantial portion of the aggregate output. • There is no cost for entering a perfectly competitive market. • Factors of production can freely move in 20 and out of the industry. • The government sets the price of the product in a perfectly competitive market.F • A perfectly competitive firm produces a substantial portion of the aggregate output. (F) • There is no cost for entering a perfectly competitive market. (T) • Factors of production can freely move in and out of the industry. (T) MONOPOLY Features of Monopoly: • Single seller of a particular good or service • No difference between firm and industry • Large number of buyers • No close substitutes -cross elasticity of demand is zero • High entry barriers • Monopolist is a price setter/maker 22 • Strength of a monopolist’s power depends on how much he can raise the price without losing all his customers- this depends on elasticity of demand, which in turn, depends on availability of substitutes • Before liberalisation, in India telephones, electricity, post& telegraph, oil &gas, railways were all monopolies. 23 Causes and Forms of Monopoly Barriers to entry- • Legal: Result of statutory regulation by government: Copy right, trade marks, government regulation, licence, tariffs and non-tariff barriers against import of goods • Technical; Technical know-how is available with only one person • Natural: Control over supply of raw materials or natural resources such as minerals, (De Beers produced 90% of entire world’s diamonds) • High costs of capital investment or economies of scale 24 Causes and Forms of Monopoly • Joint Monopoly: Through voluntary agreement, business companies jointly acquire monopoly power. e.g., Trusts, syndicates, cartels • Public Monopoly: Created for the welfare of the public- e.g., public utilities like water supply, electricity, railways, telephones • Private Monopoly: Owned an operated by private individuals or organisations- objective is profit maximisation 25 Causes and Forms of Monopoly • Simple Monopoly: Charges uniform or single price for a product to all the consumers- no discrimination between buyers or uses. • Discriminating Monopoly : Act of selling the same commodity produced under single control, at different prices to different buyers or different uses at the same time- not related to difference in cost of production 26 • Regional Monopoly- • Geographical Indication under WTO creates a barrier for global competitors • Covers plants, seeds, herbs etc 27 Pricing& Output Decisions Under Monopoly Monopolist’s demand curve is Y downward sloping (AR=D). SMC MR curve is below AR curve. SAC Equilibrium tis MR=MC (at E) An ordinate drawn from E to X axis determines profit L maximising output t OQ P Given the demand curve AR, output OQ can be sold at a K given time only at one price, M ie., QL (= OP) E AR Thus determination of outputsimultaneously =D determines the price. MR PLMK is the profit O X Q Monopolist’s Profit Whether a monopolist makes a supernormal or economic profit depends on: • Its cost and revenue conditions • Threat from potential competitors • Government policy. • If monopoly firm operates at MC=MR, its profit depends on the relative levels of AR and AC Monopolist’s Profit • if AR>AC, there is economic profit • if AR= AC, there is normal profit • if AR<AC, theoretical possibility of the monopoly firm making losses Measuring Monopoly Power • Number of firms criterion- Simplest- Fewer the number, higher the degree of monopoly power • Excess Profit Criterion- here, opportunity cost of the owner’s capital and a margin for risk are deducted from the actual profit made by the firm. • Triffin’s cross elasticity criterion - lower the cross elasticity of the product of the firm, greater the monopoly power. Measuring Monopoly Power • Concentration ratio of an industry is used as an indicator of monopoly power - relative size of firms in relation to the industry as a whole. • Cn is the percentage of market output generated by the n largest firms in the industry • Herfindahl- Hirschman Index(HHI) is a measure of the amount of competition in an industry 32 Herfindahl- Hirschman Index (HHI) • Measure of the size of firms in relation to the industry • Indicator of the amount of competition among them. • An economic concept widely applied in competition law and antitrust laws. 33 Measuring Monopoly Power • The index involves taking the market share of the respective market competitors, squaring it, and adding them together. 34 Herfindahl- Hirschman Index(HHI) • It can range from 0 to 10,000, moving from a huge number of very small firms to a single monopolistic producer. Interpretation of H- index: • Below 0.10 (or <1,000): No concentration • Between 0.10 to 0.18 (or 1,000 to 1,800): Moderate concentration. • Above 0.18 (> 1,800) : High concentration • . 35 • The United States uses the Herfindahl index to determine whether mergers are equitable to society; • The Antitrust Division of the Department of Justice considers Herfindahl indices as discussed above. • As the market concentration increases, competition and efficiency decrease and the chances of collusion and monopoly increase. Measuring Monopoly Power • While the threshold is considered to be "0.18" in the US, the EU prefers to focus on the level of change. • Increases in the HHI generally indicate a decrease in competition and an increase of market power, whereas decreases indicate the opposite. 37 • In Europe, concern is raised if there's a "0.025" change when the index already shows a concentration of "0.1". • E.g., if in a market , company B (with 10% market share) suddenly bought out the shares of company C (which also has 10%) then if this new market concentration makes the index jump to "0.172". • This would not be relevant for merger law in the U.S. (being under 0.18) but would in the EU (because there's a change of over 0.025) 38 Monopoly Power The usefulness of this statistic to detect and stop harmful monopolies is directly dependent on a proper definition of a particular market E,g., If we were to look at a hypothetical financial services industry as a whole, and found that it contained 6 main firms with 15 % market share each, then the industry would look non-monopolistic…. 39 Monopoly Power But suppose that one of those firms handles 90 % of the savings accounts and physical branches (and overcharges for them because of its monopoly), and the others primarily do commercial banking and investments. • In this scenario, people would be suffering due to a market dominance by one firm; the market is not properly defined because savings accounts are not substitutable with commercial and investment banking. 40 Monopoly Power • The problems of defining a market work the other way as well. • For example, one cinema may have 90% of the movie market, but if movie theatres compete against video stores, pubs and nightclubs, then people are less likely to be suffering due to market dominance of the cinema. 41 Monopoly Power • Another typical problem in defining the market is choosing a geographic scope. • For example, 5 firms may have 20% market share each, but may occupy five areas of the country in which they are monopoly providers and thus do not compete against each other. • A service provider or manufacturer in one city is not easily substitutable with a service provider or manufacturer in another city 42 Case of New York City Taxi Industry Market Value of Monopoly Profits • Like most US cities, New York city requires a medallion (license) to operate a taxi. • Medallions are limited in number and this confers monopoly power to owners. • Value of owning a medallion is equal to the present discounted value of the future stream of earnings from the ownership of a medallion. 43 Market Value of Monopoly Profits in New York City Taxi Industry • No of medallions in New York city remained at 11,787 from 1937 to 1996 when it was increased by only 400 to 12,187. Value of medallion rose from $10 to $250000 by 1999 or 18% per year. • Proposals to increase the number of medallions was blocked by the taxi industry lobby. If licenses to operate were freely granted, then the price of medallions would drop to zero. 44 Market Value of Monopoly Profits in New York City Taxi Industry • Instead of doing that, New York city allowed a sharp growth in the number of radio cabs, which can respond only to radio calls and can’t cruise the streets for passengers. • This sharply increased the competition in NY taxi industry and reduced profits to the taxi owners from 33% in 1993 to 11% in 1999 - from Wall Street Journal quoted in Salvatore 45 Discriminating Monopoly/ Price Discrimination 3 forms: • 1st Degree: Different rate for every unit of output- discrimination between buyers / between units • Monopolist forces every consumer to part with his entire consumer surplus-Full benefit of trade goes to trader. (Auction is one example, but it is for special products) 46 2nd degree Discrimination • 2nd Degree: Buyers are divided into different blocks or groups and then different rates charged for each block or group: • Here, consumers enjoy a part of the consumer surplus and monopolist is also able to get a part of the surplus; E.g., electricity charges, Quantity discounts 47 3rd degree Discrimination • 3rd degree: Most common type-Seller divides his buyers into sub-markets and charges a different price for each market- • Dumping is an example: High price in domestic market and low in international market. • Reasons: To dispose off surplus; to remove rivals; to take advantage of increasing returns to scale; to create new demand abroad. • As demand is elastic in international market, he has to reduce price but charges a higher price in the domestic market as domestic demand is inelastic 48 When is Price Discrimination Possible? Conditions of Price Discrimination ( When is Price discrimination possible?) 1. Consumers are unaware of the difference in prices charged 2. Price difference so small that consumers don’t bother 3. Price illusion/ irrationality 4. Markets are situated far from one another and so it is expensive to transfer goods from one market to another (Geographical distance) 49 Conditions of Price Discrimination 5) When elasticities of demand in the two markets are different: higher price for low elasticity market and lower price for high elasticity market. 6) Direct personal services such as those of doctors and lawyers where resale is not possible 7) Legal sanction provided by government: e.g., lower prices in army canteen 50 Forms of Price discrimination • Personal Discrimination: Occurs when different prices are charged to different consumers – doctors and lawyers may charge different fees for the rich and the poor • Local Discrimination: Lower prices in one locality and higher in another. e.g., dumping by charging higher prices in domestic market and lower prices in foreign markets • Trade Discrimination: Charging different rates, based on use e.g., electricity charges for domestic/ industrial/agricultural uses 51 Forms of Price Discrimination • Quality Discrimination: Hard cover editions being sold at higher prices than paper back editions of books; business class travel vs economy class in air travel • Time Discrimination: Different charges for the same commodity at different points of time- off-season air tickets; happy hours in restaurants 52 Indian Railway & Price Discrimination • On the basis of passenger categories: senior citizens, children, students, handicapped, escorts, employees--- • Class of Travel (Basis: Comfort) • Category of Train:9 categories- rajdhani, superfast, mail, Garib Rath, passenger, shuttle (Basis: time taken for travel) 53 QUIZ • TRUE OR FALSE? • Charging different prices for similar goods is pure price discrimination. • Difference in elasticities is a necessary condition for price discrimination. • Tatkal facility provided by Indian Railways is an example of ----------degree price discrimination. 54 QUIZ • Charging different prices for similar goods is pure price discrimination (F. same, not similar) • Difference in elasticities is a necessary condition for price discrimination.(T) • Tatkal facility provided by Indian Railways is an example of second degree price discrimination. 55 • In comparison with a perfectly competitive market, a monopoly market would usually generate • A) Higher output at higher price • B) Higher output at lower price • C) Lower output at higher price • D) Lower output at lower price 56 • In comparison with a perfectly competitive market, a monopoly market would usually generate • C) Lower output at higher price 57 • A monopoly is • A) One of the few producers of a homogeneous product • B) A single producer of a single product • C) One of the many producers of a homogeneous product • D) One of the many producers of a differentiated product 58 59 Monopolistic Competition Chamberlin and Joan Robinson In reality, monopoly and competition are not mutually exclusive, but markets have both elements in differing degrees Most economic situations are composites of both competition and monopoly 60 Characteristics of Monopolistic Competition Large no of firms/ sellers -Consequently no individual has any significant control over the market Absence of interdependence: (Independent decision Making) -Since the number is large and size of each firm is small, no firm can influence or is influenced by others in the market. Example of FMCG product market Freedom of entry: No barriers to entry- this leads to occurrence of only normal profits in the long run 61 Characteristics of Monopolistic Competition • In Monopolistic Competition firms compete with each other mainly not on the basis of price but on the basis of non price elements • Product differentiation and selling costs are known as non-price competition 62 Characteristics of Monopolistic Competition Product Differentiation: Core of monopolistic competition- Different firms produce similar, but not homogeneous products. Even minor changes in the same generic product , by which a seller can charge a different price e.g., tooth paste, tooth brush Cross elasticity of demand for products is very high (not infinite) in this market 63 Product differentiation may relate to A) Quality, design, packaging, trade names, raw materials used B) Conditions surrounding sale of the product- courteous approach, efficiency, credit availability, after-sale service etc 64 Characteristics of Monopolistic Competition Product differentiation gives firms some monopoly power i.e., power to control the price in a narrow circle, but in the wider circle the firm faces competition from rival producers. • Firms in effect are competing monopolies 65 Characteristics of Monopolistic Competition Selling Costs: Expenditure incurred on changing the demand and preference of the consumers - Expenditure on advertising, promotion, displays, salaries of salesmen, free samples etc.- • Unique to monopolistic competition .. 66 • Imperfect knowledge- about cost, quality, prices . • As Joan Robinson puts it: “ the imperfect market is characterised by distortions of market conditions by sellers” 67 • Identification of product groups: • A product group comprises of products that are “good” but no perfect subsitutes of each other. • E.g., Lux, Lifebuoy. Dove, Cinthol can be classified as the product group of “soaps” • Ariel, surf, Nirma and Tide can be classified as the product group of “detergents” 68 Monopolistic Competition & Advertising • Advertising: No need in monopoly and perfect competition • In this situation, makes sense for the firm to attract customers through advertising than by lowering prices 69 Monopolistic Competition Wastes of Monopolistic Competition 1. Competitive advertising ( as opposed to constructive advertising) to attract consumers to pay a premium for a particular brand 70 • Criticised by several economists because: • Advertising induces customers to spend more money because of name, rather than rational factor • Adds no value to the product being offered • Leads to brand confusion in the consumers minds • Ads by rivals may even cancel out each other, leading to increase in the AC of each firm, without corresponding increase in sales. 71 2. Excess capacity- resources are not fully utilised, leading to higher costs 72 QUIZ • Slope of DD curve for a monopolistic competition is flatter than that of a monopoly firm. (T) • A firm in monopolistic competition can not practice price discrimination. (F) • Firms under monopolistic competition will have limited discretion over price because of Customer loyalty. • If a firm in monopolistic competition increases its price slightly it will lose some customers. 73 Oligopoly: Definition and Features • Few Sellers : Naturally each seller has a sizeable share of market- • Homogeneous or differentiated products • Close Interdependence- decision of a single firm to expand or contract output affects entire market- moves and counter moves- need to predict and analyse every possible reaction of rivals before a firm takes decisions • Automobiles, steel, consumer electronics 74 Oligopoly: Definition and Features • Indeterminate demand curve: because of extreme interdependence • Price Rigidity- Price remains stuck at a certain level-No desire for a departure from prevailing price in either direction- price cutting will be followed by rival but price hike may not be and hence “sticky” prices 75 Oligopolistic Pricing Oligopolistic pricing can take 3 different forms: 1. Independent Pricing 2. Collusion Model 3. Price Leadership 1.Independent Pricing: Method of pricing its differentiated product – result of the fact that each firm has a certain monopoly power, but there is fear of retaliation by rivals - Various possibilities occur: Price wars and price rigidity 76 Collusive Oligopoly 2. Collusion Model: • When there are only a small no of firms in a market, they have a choice between cooperative and non cooperative behaviour. • Tacit or explicit collusion • A Cartel agreement represents the most complete form of collusion among oligopolists- here firms are in a cooperative mode and minimise competition among themselves- due to explicit agreement between firms – 77 Collusive Oligopoly • Joint decisions on output / price / market share or quotas- • Example of OPEC- decides on output rather than price-Has a board of control which determines the market share of each member • Sometimes tacit collusion occurs between firms without explicit agreement- Here firms quote identical prices • Example: Indian cement and steel markets 78 Collusive Oligopoly Barriers to Collusive Oligopoly: • Considered illegal as it converts oligopoly into monopoly - Firms may cheat by giving secret price concessions and thereby increasing the market share • Slow and lengthy process of cartel negotiations • Rigidity of negotiated prices - Some cartel members may be political rivals such as Iraq, Kuwait and Iran in OPEC 79 Price Leadership 3. Price Leadership: It is an informal position in most oligopolistic markets. It may emerge spontaneously due to technical reasons such as size, efficiency, economies of scale, brand image or the firm’s ability to forecast market conditions accurately • Typically, leadership role is played by a dominant firm (largest in the industry) and smaller ones follow-(Example- Bajaj scooter, Camlin ink) 80 Price Leadership • Sometimes price leadership is barometric-Here one of the firms (not necessarily the dominant one) takes lead in announcing a price change, especially when a change is due but is not implemented due to uncertainty in the market – The barometric firm is supposed to have a better knowledge of the changing environment of the market than others • Price leadership often serves as a means to price discipline and price stabilisation 81 Kinked Demand Curve • Once a general pricing decision is taken under any of the above models, it remains fixed for an extended period. • Kinked demand curve theory by Paul Sweezy explains price rigidity under oligopoly • 2 parts of demand curve of a firm have different elasticities- one for price increase and another for price decrease- Former is more elastic than latter 82 Kinked Demand Curve The AR curve or demand curve has a kink at the point K at D K which it operates P MC1 and price is OP. M MC2 DK: Demand is more M Cost/Revenue C elasic. Raising price M 1 above OP will cause sizeable decline in demand D1 KD1: Inelastic MR segment. Price cut O M output will be followed by O Q R rivals M M1 83 Kinked Demand Curve • MR Curve is discontinuous as a result of kink in AR curve • MC passes through the dotted portion of the MR curve. Hence , a change in MC has no effect on price and output 84 Industrial Concentration in US Industry Four Firm Ratio Cigarettes 93 Breakfast cereals 85 Household Refrigerators 82 Newspapers 25 Men’s clothing 18 Women’s Dresses 11 85 Game Theory • First systematic attempt was made by von Neumann and Morgenstern • Martin Shubik is considered the most prominent proponent of game theory 86 • Nature of the problem faced by an oligopolistic firm is best explained by Prisoner’s Dilemma: • A and B are arrested by CBI on suspicion of involvement in a crime and interrogated separately by the CBI, with the following conditions disclosed to them: 87 1. If you confess your involvement in the crime, you will get 5 years imprisonment. 2. If you deny your involvement and your partner denies it too, you will be set free for lack of evidence. 3. If one of you confesses and turns approver, and the other does not, then the one that confesses will get 2 years imprisonment and one who does not confess gets 10 years imprisonment . 88 • Given the conditions, each suspect has 2 options- i) To confess ii) Not to confess • Both have a dilemma • While taking a decision both have a common objective- to minimise the period of imprisonment 89 Game Theory • Game Theory models include players, strategies and payoffs • Players : Decision makers • Strategies: Choices to change price, develop new products, undertake new advertising campaigns etc • Payoff: Outcome or consequence of a strategy • Payoff Matrix: Table giving the payoffs from all the strategies open to the firm and the rival’s responses 90 • A firm needs to anticipate- • Counter moves by rivals • Pay-off when • a) rival firm does not react • B) rival makes a counter move by raising its ad expenditure 91 OPEC’s Price Making Power • 12 members- Saudi largest producer • The Organization of Petroleum Exporting Countries (OPEC) is a cartel of twelve countries made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. The organization has maintained its headquarters in Vienna since 1965, and hosts regular meetings among the oil ministers of its Member Countries. Indonesia 's membership from OPEC was voluntarily suspended recently as it became a net importer of oil. 92 • During 1970s undisputed power-In 1980s OPEC was accused of behaving like a “clumsy cartel” – • Non cooperative behaviour from members with lower reserves such as Qatar, Indonesia and Venezuela. Because of their lower reserves and intention of making quick profits, these often produced in excess of the stipulated individual quota 93 OPEC’s Price Making Power • When prices nosedived abnormally in 1998, OPEC successfully executed 2 successive production cuts - But since then erosion of OPEC’s monopoly power as a price maker -Surge in non OPEC production and 94 OPEC’s Price Making Power • Core problem is price of oil is no more fixed in the spot market where physical trading takes place but on futures market where only paper barrels are traded • Only an insignificant part of oil traded on NYMEX is ever physically delivered. 95 OPEC’s Price Making Power • Many players are involved in futures trading that are not involved in physical trading of crude (true of all commodities)- floor traders, fund managers, refiners, producers, financial institutions and speculators- complicates process of decision making within OPEC 96 OPEC’s Price Making Power OPEC’s ability to influence prices depends on- • Its ability to influence so many players, including level of stocks and inventories that the refineries are holding • Size of speculative positions • Flow of hedge funds in and out of the market • Traders’ bearish or bullish sentiments • Existence or erosion of spare capacity 97 Comparison of different Market Structures Feature Perfect Monopoly Monopolisti competition c competition No of Many One Large sellers Nature of Homogene Homogene Differentiat goods ous ous ed Entry Free Barriers Unrestricte d 98 Degree of Zero Absolute Limited Comparison of different Market Structures Feature Perfect Monopoly Monopolisti competition c competition Cost Production Production Production Elements cost cost cost+ Selling cost Long run Normal Super- Normal Profits normal Nature of Elastic Inelastic Relatively 99 Demand inelastic Feature Perfect Monopoly Monopolisti competition c competition Pricing Price taking Price- Price- making: making: i) Uniform Uniform ii) Price price discriminati on 100
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