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MARKET
DYNAMICS
How changes in market conditions lead to shifts in demand or supply, and adjustment to
a new equilibrium price and quantity.
That market prices can act as messages (both to individuals and between markets)
about the relative scarcity of goods.
How prices are determined in financial markets, and how they change from minute to
minute.
Why some prices dont change, and some markets do not clear.
See www.core-econ.org for the full interactive version of The Economy by The CORE Project.
Guide yourself through key concepts with clickable figures, test your understanding with multiple choice
questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements,
watch economists explain their work in Economists in Action and much more.
Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po
PAST ECONOMISTS
FRIEDRICH HAYEK
The Great Depression of the 1930s ravaged
the capitalist economies of Europe and
North America, throwing a quarter of the
workforce out of work in the US. During the
same period the centrally planned economy
of the Soviet Union continued to grow
rapidly under a succession of five-year plans.
Even the arch-opponent of socialism, Joseph
Schumpeter, had conceded: Can socialism
work? Of course it can... There is nothing
wrong with the pure theory of socialism.
Friedrich Hayek (1899-1992) did not think
so. Born in Vienna, he was an Austrian (later
British) economist and philosopher who
believed that the government should play a minimal role in the running of society.
He was against any efforts to redistribute income in the name of social justice. He
was also an opponent of the policies advocated by John Maynard Keynes designed
to moderate the instability of the economy and the insecurity of employment.
Hayeks book Road to Serfdom was written against the backdrop of the second world
war, where economic planning was being used both by German and Japanese fascist
regimes and, on the Allied side, by the Soviet communist authorities and British and
American governments. He argued that well-intentioned planning would inevitably
lead to a totalitarian outcome.
His key idea, one that revolutionised how economists think about markets, is that
prices are messages: they convey valuable information about how scarce a good is,
information that is available only if prices are free to be determined by supply and
demand, rather than by the decision of a planner.
The advantage of capitalism, to Hayek, is that it provides the right information to the
right people. In 1945 he wrote in The Use of Knowledge in Society:
Which of these systems [central planning or competition] is likely to be more
efficient depends on which of them we can expect [to make] fuller use of the
existing knowledge. And this, in turn, depends on whether we are more likely to
succeed in putting at the disposal of a single central authority all the knowledge
which ought to be used but which is initially dispersed among many different
individuals, or in conveying to the individuals such additional information as they
need in order to enable them to fit their plans in with those of others.
80 Ecuador
Peru
70 Bolivia
60
Thousands of tonnes
50
40
30
20
10
0
1,400
Bolivia
1,200
Peru
1,000
$/tonne
800
600
400
200
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
$ millions
35
Canada
EU-27
30
25
20
15
10
5
0
2001
2003
2005
2007
2009
2011
20
Price, $
Supply
15
B
10
10
15
20
25
30
35
Quantity of books
Original demand
New demand
40
45
50
55
60
INTERACT
Follow figures click-by-click in the full interactive version at www.core-econ.org.
This would lead to an increase in the demand for books. At each possible price there are
more students wanting to buy, so the demand curve shifts to the right, as shown by
the brown line in Figure 2.
There is a new equilibrium with a price of $10, at which 32 books are sold. How does
the market adjust to this point? At the original price of $8, there would be more
buyers than sellers: that is, excess demand. As they become aware of the changed
market conditions, some sellers may raise their prices. Some students who would not
have sold their books at $8 now want to sell: the quantity supplied increases along
the supply curve until the market clears at P = $10. There is a new equilibrium at
point B, with a price of $10, at which 32 books are sold. Notice, however, that not all
the students who would have bought at $8 purchase the book at the new equilibrium.
Some of them no longer want to buy at $10. These are the students with a willingness
to pay shown by the part of the demand curve between $8 and $10.
Although we have described how the market might adjust, the model of supply
and demand that we are using focuses on the equilibria; it does not tell us exactly
what happens in the process of moving from one perfectly competitive equilibrium
to another. But it is plausible to suppose that some sellers would raise their prices
before others. While the market istemporarilyout of equilibrium they are not
constrained to be price takers: excess demand allows them to raise their prices
without losing customers.
When using terms such as increase in demand its important to be careful. When we
say this, we mean that demand is higher at each possible price: that is, the demand
curve has shifted. In response to the shift there is a change in the price and this leads
to an increase in the quantity supplied. In the diagram this change is a movement along
the supply curve. The supply curve has not shifted (the number of sellers and their
reserve prices have not changed), so we would not call this an increase in supply.
As an example of an increase in supply, think again about the market for bread in
one city that we studied in Unit 8. Remember that the supply curve represents the
marginal cost of producing bread. Suppose that bakeries discover a new technique
that allows each worker to make bread more quickly. This will lead to a fall in the
marginal cost of a loaf at each level of output. In other words, the marginal cost curve
of each bakery shifts down.
4.0
3.5
Price,
3.0
New supply
(MC)
2.5
A
2.0
1.5
1.0
Demand
0.5
0.0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000 10,000
LEIBNIZ
For mathematical derivations of key concepts, download the Leibniz boxes from
www.core-econ.org.
10
11
52.9
10.40
77.0
136.6
BAVARIA
70.0
127.3
BOHEMIA
61.5
101.2
FRANCE
93.8
149.2
HAMBURG
67.1
108.7
HESSE-DARMSTADT
76.7
119.7
HUNGARY
39.0
92.3
LOMBARDY
88.3
119.1
MECKLENBURG
-SCHWERIN
72.9
110.9
PAPAL STATES
74.0
105.1
PRUSSIA
71.2
110.7
SAXONY
73.3
125.2
SWITZERLAND
87.9
146.7
WRTTEMBERG
75.9
128.7
BELGIUM
93.8
140.1
BREMEN
76.1
109.5
BRUNSWICK
62.3
100.3
DENMARK
66.3
81.5
NETHERLANDS
82.6
136.0
OLDENBURG
52.1
79.3
ENGLAND
115.3
134.7
FINLAND
73.6
73.7
NORWAY
89.3
119.7
RUSSIA
50.7
44.1
SPAIN
105.3
141.3
SWEDEN
75.8
81.4
Immediate
constitutional
change 1848
No revolution
1848
Source: Berger, H. and Spoerer, M. 2001. Economic crises and the European revolutions of 1848. The
Journal of Economic History, 61(02), pp. 293-326.
12
another reason for a change in supply in a market is the entry of more firms,
or the exit of existing firms. So far in our analysis of the bread market we have just
assumed that there are 50 bakeries. But, as we discussed in Unit 8, if the profits of
the bakeries were above normal profits then other firms might want to invest in
the baking business. Conversely, if profitability fellperhaps as a result of a fall in
demandeconomic profits could become negative, causing some bakeries to close
down.
Lets start again from the original equilibrium in the bread market, in which 5,000
loaves are produced, and sold at 2 each. There are 50 bakeries, and we will assume
they all have the same costs: the isocost and marginal cost curves are shown in Figure
4. Remember that isoprofit curves slope down where the marginal cost is less than
the price, because making one more loaf would increase profit unless the price went
down, and similarly they slope up where the marginal cost is above the price. Since
the market is competitive, each bakery is producing at the point on its own marginal
cost curve, where price equals 2, making 100 loaves. As in Unit 8, the lightest
blue isoprofit curve shows points at which economic profits are zero (price equals
marginal cost, and the firm is earning normal profits). You can see that, when price is
equal to 2 and quantity is equal to 100, the bakery is above this curve at point Aso
it is making a positive economic profit.
7
6
Price, Cost,
5
Marginal cost curve
3
2
Isoprofit curve: 80
Zero economic profit (AC curve)
1
0
20
40
60
80
100
120
140
160
180
200
Figure 4. Isoprofit curves and marginal cost curve for the bakery.
13
4.0
3.5
Price,
3.0
2.5
A
2.0
1.5
1.0
Demand
0.5
0.0
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
14
1. Suppose there was an unexpected increase in demand for quinoa in the early
2000s. What would you expect to happen to the price and quantity initially?
2. Assuming that demand continued to rise over the next few years, how do you
think farmers responded?
3. Why did the price stay constant until 2007?
4. How could you account for the rapid price rise in 2008 and 2009?
5. Would you expect the price to fall eventually to its original level?
The graphs in Figure 1 are taken from a World Bank blog that tells you more about
quinoa: LINK.
prices in some markets are constantly changing. The graph in Figure 6 shows
how News Corps share price on the Nasdaq stock exchange fluctuated over one
day in May 2014 and, in the lower panel, the number of shares traded at each point.
Soon after the market opened at 9.30am the price was $16.66 per share. As investors
bought and sold shares through the day, the price reached a low point of $16.45 at
both 10am and 2pm. By the time the market closed, with the price at $16.54, nearly
556,000 shares had been traded.
Remember from Unit 6 that owning a share in a firm (also known as common stock)
gives the shareholder a right to receive a certain proportion (depending on how many
shares there are in total) of a firms profitsits earnings after payment of interest
and taxes. A portion of the profits are paid out to shareholders as dividends, while
the rest is reinvested in the firm to maintain and expand its ability to generate future
profits. The price at which shareholders are willing to buy or sell depends on what
they believe about the companys future profitability. In addition, since they may
want to sell their shares in future, they need to think about how the price might
changewhich depends on what other people believe about future profits.
15
09:50
10:10
10:30
10:50
11:10
11:30
11:50
12:10
12:30
12:50
13:10
13:30
13:50
14:10
14:30
14:50
15:10
15:30
15:50
09:50
10:10
10:30
10:50
11:10
11:30
11:50
12:10
12:30
12:50
13:10
13:30
13:50
14:10
14:30
14:50
15:10
15:30
15:50
140
120
100
80
60
40
20
0
09:30
Share price, $
16.70
16.65
16.60
16.55
16.50
16.45
16.40
09:30
16
Figure 6. News Corps share price and volume traded, 7 May 2014.
Source: Bloomberg L. P., accessed 28 May 2014.
In the market for shares in News Corp, each of the existing shareholders has a reserve
price at which the shareholder would be willing to sell. Others are in the market to
buy, as long as they can find an acceptable price. Figure 7 shows demand and supply
curves for the potential buyers and sellers in a particular time periodsay an hour.
The curves show the hourly volume of shares that would be demanded and supplied
at each price.
Initially the market is in equilibrium at A: 6,000 shares are sold per hour, at a price
of $16.50. If there is some good news about the future profitability of News Corp, this
will shift both the supply and the demand curves simultaneously. There will be more
buyers at each price, but the number of willing sellers decreases. Both effects will
raise the pricewhich is why we see large changes in share prices, even when the
volume of trade doesnt alter much. The new market equilibrium is at B; the price has
risen from $16.50 to $16.65. In this illustration demand changes more than supply, so
volume rises too. Unlike markets for ordinary goods and services, there can be large
changes in the prices of financial assets like shares when very few trades occur.
17
Share price, $
Rise in demand
B
16.65
16.50
Fall in supply
18
Bid
Ask
PRICE($)
SIZE
PRICE($)
SIZE
16.56
400
16.59
500
16.55
400
16.60
700
16.54
400
16.61
800
16.53
600
16.62
500
16.52
200
16.63
500
Figure 8. Bid and ask prices for News Corp (NWS) shares.
Source: Yahoo! Finance, accessed 8 May 2014.
Given this situation, a buy order for 100 shares at $16.57 would remain unfilled and
would enter the book at the top of the bid column. However, a bid for 600 shares at
$16.60 would be filled immediately, since it can be matched against existing limit
sell orders. 500 shares would trade at $16.59 apiece, and 100 shares would trade at
$16.60. Whenever a buy order is immediately filled, trade occurs at the best possible
price for the buyerthe ask price; similarly if a sell order is placed and immediately
filled from existing orders, trade occurs at the best possible price for the sellerthe
bid price.
DISCUSS 4
Use the data from the NWS order book in Figure 8 to plot supply and demand curves
for shares. Explain why the two curves do not intersect.
9.4 BUBBLES
19
20
EINSTEIN 1
Calculating the present value of an asset: You may be wondering how it is possible to
work out the price you would be willing to pay for a share that you expect to deliver
dividends in the future. For example, suppose you are considering investing in an
asset that will pay $100 in one years time, and no other dividends. You probably
wouldnt pay $100 without considering alternative investments. Suppose, for
example, that the best alternative you can find is to invest $100 now in a savings
account at 3% annual interest. Then you would receive $100 x 1.03 = $103 in a years
timea better use of your initial $100.
But following this line of reasoning, if you invested $100/1.03 = $97.09 in the savings
account, you would have $100 in a years time. So, if the current interest rate is 3%,
owning an asset consisting of $100 in a years time is equivalent to having $97.09
now. We say that the present value of this asset is $97.09. Given the alternatives
available to you, you would be willing to pay at most $97.09 to buy it.
In principle you can use this method to work out the present value of any asset that
delivers payments in the futurejust work out the present value of each expected
payment, which depends on the rate of return on alternative investments over the
same time period, and add them together. The more difficult problem in evaluating
an asset is to work out what you expect the dividends to be.
To get a sense of the extent of volatility in asset prices, consider Figure 9, which
shows the value of the Nasdaq Composite Index between 1995 and 2004. This index
is an average of prices for a set of stocks, with companies weighted in proportion to
their market capitalisation. The Nasdaq stocks include many fast-growing and hardto-value companies in technology sectors.
21
6,000
5,000
4,000
3,000
2,000
Jan 04
Jan 03
Jan 02
Jan 01
Jan 00
Jan 99
Jan 98
Jan 97
Jan 95
Jan 96
1,000
The index began the period at less than 750 and had risen in five years to more
than 5,000. The index increased more than six-fold between 1995 and 2000 with a
remarkable annualised rate of return of around 45% (find out how to calculate this
in EINSTEIN 2). It then lost two-thirds of its value in less than a year, and eventually
bottomed out at around 1,100, almost 80% below its peak. The episode has come to
be called the tech bubble.
EINSTEIN 2
Calculating compound annual growth rates (CAGRs) and indices: In only five years
the Nasdaq Composite Index rose from 750 to 5,000. We can calculate the average
annual growth of the Nasdaq over this period by calculating a compound annual
growth rate. This measure takes into account the fact that this years growth builds
on last years growth. For example, if a stock was priced at $10 and then rose by 10%
over the next year, it would end the year at $11; a gain of $1. If that stock then rose
10% again over the next year, it would rise to $12.10; a gain of $1.10. We can see that
the same growth rate gives a bigger price gain over the second year because the
stock started at a higher price. The compound annual growth rate for the stock over
the two years is 10%, but it has risen 21% from its original price.
22
The formula for calculating a compound annual growth rate (CAGR) is:
CAGR = (final value/initial value)(1/n) - 1
where n is the number of years over which the growth has taken place. In our
example, the number of years is five.
Hence the compound annual growth rate of the Nasdaq between 1995 and 2000 is:
CAGR = (5000/750)(1/5) - 1 = 46.14%
We can also use some simple maths to create an index. An index typically allocates
a value of 100 to one year in a series, and then shows how each of the other years in
the series compares to that year. For example, if we rebase the Nasdaq stock index
at 100 in 1995 then we can see how other years compared. A value of 200 in the index
would indicate the Nasdaq had doubled from 750 to 1,500.
Rebasing a series is simple. First you choose the reference year and allocate it a
value of 100. Then for each other year in the series you use this calculation:
(value of series this year/value of series in reference year) x 100.
In our example, we have two data points: 750 in 1995 and 5,000 in 2000. We set 1995
as the reference year. The value of the index in the year 2000 is therefore:
(5000/750) x 100 = 666.66
From this we can easily see that the Nasdaq rose over six-fold between 1995 and
2000.
Both the CAGR and indices can be easily calculated from a set of data in a
spreadsheet program on a computer.
23
24
Share price, $
To see how irrational exuberance might work, look at Figure 10. Initially the price of
a share is $50 on the darkest red demand curve. When potential traders and investors
receive good news about expected future profitability, the demand curve shifts to
the right, and the price increases to $60. (For simplicity we assume that the supply
curve doesnt move). But now suppose that potential buyers, observing the price
rise, treat it as further good news. Individuals might believe that the price has risen
because other people have received news that they themselves hadnt heard, and
adjust their own expectations upwards. Or they may think there is an opportunity for
speculation: to buy the stock now because they will be able to sell to other buyers at a
profit later. Either way, demand increases again. The demand curve shifts up simply
because the price has been increasing, and the price rises again to $70. This further
rise may lead to another shift in demand, continuing the process.
Demand curve 4
Demand curve 3
Demand curve 2
Demand curve 1
80
Supply curve
70
60
50
Volume of trade
25
Fall in
demand
Share price, $
26
Supply curve
New supply curve
80
50
Demand curve
Increased
supply
Volume of trade
27
1,400
1,200
1,000
800
600
400
200
0
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
If the price of an asset has been driven up by irrational exuberance, there should be
opportunities for those who are well informed about the value to profit from their
superior information. So if the rise in the Nasdaq index was indeed a bubble, why did
those who identified it fail to profit by placing gigantic bets on a major price decline?
As it happens, many large investors did place such bets, including some well-known
fund managers on Wall Street. The manner in which these bets were placed on the
bubble bursting was by selling short, or shorting: borrowing stock and immediately
selling it, with the intention of buying it back (to return to the owner) after the price
crashes. This is an extremely risky strategy, since it requires accuracy in timing the
crashif prices continue to rise, the losses can become unsustainable.
Bitcoin brings no intrinsic benefit to the holder; its fundamental value comes from
being able to use it to purchase goods and services where it is accepted (these places
are, in 2014, few and far between). As with other assets there is also the possibility of
selling it to someone else at a future date. Belief in the remote possibility that it will
emerge as a widely accepted global currency sustains its price. More importantly, the
price is also sustained by the difficulty of betting on a decline in value, and because
the investors who bet on an increase in 2013 made extravagant gains. Even if it were
possible to borrow and sell the asset (that is, to sell short), and a group of well-funded
individuals were certain that its price would eventually collapse to zero, placing big
bets on a crash would carry large risks. Even if they were eventually proved right,
they may suffer heavy losses if they got the timing wrong.
In fact, many of those buying the asset may also be convinced of an eventual crash,
but hoping to exit the market before it happens. This was the case during the tech
bubble when Stanley Druckenmiller, manager of the $8bn Quantum Fund, held
28
29
Price,
The market for The Times is not perfectly competitive: it is a differentiated product,
so the producer has some discretion over the price that it sets. We can analyse the
market for a newspaper as we did for other differentiated products in Unit 7. The
marginal cost of one newspaper, which includes printing and distribution costs,
does not change very much with circulation. So in Figure 13 we show the marginal
cost as constanta horizontal line. The cost of producing the content of the paper
is a fixed cost, independent of circulation, and this may be quite high. The lightest
blue isoprofit line corresponds to economic profits of exactly zero: it shows what the
price needs to be at each level of circulation for the newspaper to just cover its fixed
costs as well as its marginal costs. Lets begin with the light red demand curve: we
can see that the newspaper maximises profits when it sells 113,000 newspapers. This
is where the demand curve is just tangent to the darkest blue isoprofit curve. The
newspaper sets its profit-maximising price at 1.10.
1.10
1.05
65,000
113,000
Quantity of newspapers
30
EINSTEIN 3
In Unit 7 we found a formula for the firms markup of the price above marginal cost:
(P-MC)/P = 1/elasticity
where the elasticity depends on the slope of the demand curve:
elasticity = P/Q Q/P = P/Q 1/slope
So the profit margin is:
P-MC = Q slope
In the example illustrated in Figure 8, when demand for newspapers falls, Q
decreases at each price level, but the slope rises, so Q slope stays approximately
constant. This means that the profit margin stays approximately the same, despite
the fall in Q.
Many posted-price markets involve large fixed costs of setup and operation, and
sellers therefore welcome increases in demand: they respond by raising output rather
than prices. The newspaper illustrated in Figure 13 makes higher profit when its
output is higher, at 113,000, because the cost per newspaper is lower than at 65,000.
Even for manufactured goods with increasing marginal costs of production, the
immediate effect of a change in demand will be on inventories, not on prices. If
demand rises, stored stock declines faster than expected, and shops order more
in each of the examples we have discussed so far, the market clears: adjustments
of price or quantity take place to equalise supply and demand. Now we look at some
cases where markets dont clear, but remain in a state of excess supply or excess
demand.
Tickets for the 2013 world tour by Beyonc sold out in 15 minutes for the Auckland
show in New Zealand, in 12 minutes for three UK venues, and in less than a minute
for Washington DC in the US. When American singer Billy Joel announced a surprise
concert in his native Long Island, New York in October 2013, all available tickets
were snapped up in minutes. In both cases its safe to say that there were many
disappointed buyers who would have paid well above the ticket price: at the price
chosen by the concert organisers, demand exceeded supply.
We see excess demand for tickets for sporting events, too. The London organising
committee for the 2012 Olympic Games received 22 million applications for 7 million
tickets. Figure 14 is a stylised representation of the situation for one Olympic event.
The number of available tickets, 40,000, is fixed by the capacity of the stadium. The
ticket price at which supply and demand are equal is 225. The organising committee
do not choose this price, but a lower price of 100; at this price 70,000 tickets are
demanded. There is excess demand of 30,000 tickets.
31
225
Ticket price,
32
Economic
rent
100
Excess
demand
Demand curve
0
40
70
33
34
in december 2013,on a cold and snowy Saturday in New York City, demand for taxi
services rose appreciably. The familiar metered yellow and green cabs, which operate
at a fixed rate (subject to minor adjustments for peak and night-time hours), were
hard to find. Those looking for taxis were accordingly rationed, or faced long waiting
times.
But there was an alternative availableanother example of a secondary market: an
on-demand, app-based taxi service called Uber (LINK), which at the beginning of 2014
operated in 67 cities in 25 countries. This recent entrant in the local transportation
market uses a secret algorithm that responds rapidly to changing demand and supply
conditions. Standard cab fares do not change with the weather, but Ubers prices
can change substantially. On this December night Ubers surge-pricing algorithm
resulted in fares that were more than eight times the base rate charged by the yellow
and green cabs. This spike in pricing choked off some demand and also led to some
increased supply, as drivers who would have clocked off remained on the road and
were joined by others.
35
Housing rent,
1,100
830
500
Market
clearing rent
Economic
rent
Excess
demand
Controlled rent
12,000
Number of tenancies
36
9.8 CONCLUSION
But not all prices send the right message. We have already seen how the wrong
messages are sent when bubbles develop. In the next unit we describe the conditions
under which markets send the right messages, and the reasons why they sometimes
fail to do so.
37
38
1. In a competitive market with flexible prices, shifts of demand or supply are followed
by an adjustment of the price to reach a new market-clearing equilibrium.
2. In markets for financial assets, supply and demand shift as traders receive new
information. The price adjusts in a continuous double action to reconcile supply and
demand.
3. A bubble occurs if the price of an asset deviates from its expected fundamental value,
which could happen if traders expectations were influenced by price changes.
4. In markets where price-setting firms post prices, quantities rather than prices may
adjust in response to changes in demand.
5. Firms or governments may choose to set a price that does not clear the market, giving
rise to excess demand or supply, and potential economic rents.
6. Prices determined by markets are messages about the scarcity of goods and services,
which respond to changes in economic circumstances and motivate all participants to
change their decisions to reflect the new conditions.
39
40
Rent control
This brief economic analysis of the recent introduction of rent controls in Paris
points out the counter-productive effects: LINK.
Bosvieux, J. (translated Waine, O.). 2012. Rent control: a miracle solution to the housing
crisis? Metropolitics, 21 November.
Richard Arnott argues that economists should rethink their traditional opposition:
LINK.
Arnott, R. 1995. Time for revisionism on rent control? Journal of Economic Perspectives,
9(1), pp. 99-120.
MORE
Economic crises and the European revolutions of 1848: LINK.
Berger, H. and Spoerer, M. 2001. Economic crises and the European revolutions of 1848. The
Journal of Economic History, 61(02), pp. 293-326.
Paul Masons article compares the data in 1848 and 2011: LINK.
Mason, P. 2011. Idle Scrawl: Revolutions and the price of bread: 1848 and now. April 21,
BBC blogs.
Varieties of capitalism
David Soskice and Peter Hall discuss interactions within firms and markets,
distinguishing between liberal market economies and coordinated market
economies: LINK.
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