Chapter 5
Public Spending
and Public Choice
Introduction
The U.S. Postal Service (USPS) delivers nearly 40
percent of the world’s mail. Yet, its annual mail volume
ha...
Learning Objectives
• Explain how market failures, such as
externalities, might justify economic
functions of government
•...
Learning Objectives (cont'd)
• Analyze how Medicare affects the incentives
to consume medical services
• Explain why incre...
Chapter Outline
• What a Price System Can and Cannot Do
• Correcting for Externalities
• The Other Economic Functions of
G...
Did You Know That ...
• A woman searching for scrap metal in the Eastern
European nation of Georgia accidentally halted al...
What a Price System Can and Cannot
Do
• In its most ideal form, a price system allows
resources to move from lower-valued ...
What a Price System Can and Cannot
Do (cont'd)
• Market Failure
– A situation in which the unrestrained market
economy lea...
Correcting for Externalities
• In a pure market system, economic
efficiency occurs when individuals know and
must bear the...
Correcting for Externalities (cont'd)
• Market failure: an example
– Assume
• No government regulation against pollution
•...
Correcting for Externalities (cont'd)
• Market failure: an example
– Market failure occurs
• Steel mill does not pay for t...
Correcting for Externalities (cont'd)
• Externalities
– Occur when the consequences of an economic
activity spill over to ...
Correcting for Externalities (cont'd)
• Externalities are examples of market
failures
• Pollution is an example of a negat...
Figure 5-1 External Costs and Benefits,
Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.

5-14
Figure 5-1 External Costs and Benefits,
Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved.

5-15
Correcting for Externalities (cont’d)
• Resource misallocations of externalities
– External costs—market overallocates
– E...
Example: Hungary’s Tax on
Prepackaged Snacks
• The Hungarian government has determined
that there are external spillovers ...
Correcting for Externalities (cont'd)
• How the government can correct positive
externalities
– Government financing and p...
Policy Example: Stop the Presses for
Subsidies!
• As newspaper readership has declined over
the past decade, some governme...
The Other Economic Functions of
Government
• Providing a legal system
• Promoting competition
• Providing public goods
• E...
The Other Economic Functions of
Government (cont'd)
• Providing a legal system
– Enforcing contracts
– Defining and protec...
The Other Economic Functions of
Government (cont'd)
• Promoting competition
– Market failure may occur if markets are not
...
The Other Economic Functions of
Government (cont'd)
• Antitrust Legislation
– Laws that restrict the formation of monopoli...
The Other Economic Functions of
Government (cont'd)
• Providing public goods
– Goods to which the principle of rival
consu...
The Other Economic Functions of
Government (cont'd)
• What truly distinguishes public goods from
all private goods is that...
The Other Economic Functions of
Government (cont'd)
• Characteristics of public goods
1. Can be used by more and more peop...
Example: Private Companies Look to Place
Humans in Orbit – and Beyond

• Bigelow Aerospace, a private firm, has
designed a...
The Other Economic Functions of
Government (cont'd)
• Free-Rider Problem
– Arises when some individuals take advantage of
...
The Other Economic Functions of
Government (cont'd)
• Ensuring economy-wide stability
– Smooth ups and downs in overall bu...
The Political Functions of
Government
• Government-Sponsored Goods
– Goods deemed socially desirable through the
political...
The Political Functions of
Government (cont'd)
• Income redistribution: includes progressive
income tax system and transfe...
The Political Functions of
Government (cont'd)
• Transfer Payments
– Money payments made by governments to
individuals for...
The Political Functions of
Government
• Transfers in Kind
– Payments that are in the form of goods and
services
– Include ...
Public Spending and Transfer
Programs
• Government Outlays
– All federal, state and local spending
– Examples
• Defense, i...
Figure 5-2 Total Government Outlays
over Time

Sources: Facts and Figures on Government Finance, various issues; Economic ...
Public Spending and Transfer
Programs (cont'd)
• Publicly subsidized healthcare
– Medicare
• Began in 1965
• Pays hospital...
Figure 5-3 Federal Government Spending
Compared to State and Local Spending

Sources: Economic Report of the President, Ec...
Figure 5-4 The Economic Effects of
Medicare Subsidies

Copyright ©2014 Pearson Education, Inc. All rights reserved.

5-38
Public Spending and Transfer
Programs (cont’d)
• To increase the quantity of medical care,
the government pays a subsidy
–...
Policy Example: The Great Underestimates of
Health Care Expenses
• In 1965, officials estimated the 1990 cost of
Medicare ...
Public Spending and Transfer
Programs (cont’d)
• Health Care Subsidies Continue to Grow
– The cost of Medicare is now $550...
What If . . . the federal government reduces outof-pocket prices consumers pay for health care
services?

• If out-of-pock...
Public Spending and Transfer
Programs (cont’d)
• Economic Issues of Public Education
– State and local governments provide...
Public Spending and Transfer
Programs (cont’d)
• The Incentive Problems of Public Education
– Various measures of performa...
Example: A Weak Relationship Between
Spending and Schooling Results
• Alaska, New Jersey, New York, Vermont,
and Washingto...
Collective Decision Making: The
Theory of Public Choice
• Collective Decision Making
– How voters, politicians, and other ...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Theory of Public Choice
– The study of collective decis...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Similarities in market and public-sector
decision makin...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Incentive Structure
– The system of rewards and punishm...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Differences between market and collective
decision maki...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Differences between market and collective
decision maki...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Government or Political Goods
– Goods (and services) pr...
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Differences between market and collective
decision maki...
You Are There: The U.S. Government Ensures
That an Airport is “Convenient”

• The free parking, short security lines, and
...
Issues & Applications: The GovernmentSponsored U.S. Postal Service
• Operating as a government-sponsored
enterprise, the U...
Summary Discussion of Learning
Objectives
• How market failures such as externalities might
justify economic functions of ...
Summary Discussion of Learning
Objectives (cont'd)
• Political functions of government that lead
to its involvement in the...
Summary Discussion of Learning
Objectives (cont'd)
• The effect of Medicare on incentives to
consume medical services
– Su...
Summary Discussion of Learning
Objectives (cont'd)
• Why bigger subsidies for public schools do
not necessarily translate ...
Summary Discussion of Learning
Objectives (cont'd)
• Central elements of the theory of public choice
– Collective decision...
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Chapter 5 Powerpoint

  1. 1. Chapter 5 Public Spending and Public Choice
  2. 2. Introduction The U.S. Postal Service (USPS) delivers nearly 40 percent of the world’s mail. Yet, its annual mail volume has declined by more than 20 percent since 2006. Continuation of USPS operations is dependent on the more than $15 billion in loans provided by the federal government. Why does government sponsor the provision of certain items, rather than allowing private firms to supply them? We will explore this question in Chapter 5. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-2
  3. 3. Learning Objectives • Explain how market failures, such as externalities, might justify economic functions of government • Distinguish between private and public goods and explain the nature of the freerider problem • Describe the political functions of government that entail its involvement in the economy Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-3
  4. 4. Learning Objectives (cont'd) • Analyze how Medicare affects the incentives to consume medical services • Explain why increases in government spending on public education have not been associated with improvements in measures of student performance • Discuss the central elements of the theory of public choice Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-4
  5. 5. Chapter Outline • What a Price System Can and Cannot Do • Correcting for Externalities • The Other Economic Functions of Government • The Political Functions of Government • Public Spending and Transfer Programs • Collective Decision Making: The Theory of Public Choice Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-5
  6. 6. Did You Know That ... • A woman searching for scrap metal in the Eastern European nation of Georgia accidentally halted all Internet communication to Armenia? • In shoveling below ground to find unused wires containing copper, the woman sliced through a fiber optic cable. • In her defense, the woman claimed that she was pursuing her own self-interest by looking for scrap metal that could be sold for a profit. • This event is an example of how the market system may cause negative spillovers for third parties. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-6
  7. 7. What a Price System Can and Cannot Do • In its most ideal form, a price system allows resources to move from lower-valued to higher-valued uses through voluntary exchange – Economic efficiency arises when all mutually advantageous trades have taken place • There are, however, situations when a price system does not generate the desired results Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-7
  8. 8. What a Price System Can and Cannot Do (cont'd) • Market Failure – A situation in which the unrestrained market economy leads to too few or too many resources going to a specific economic activity • Prevents economic efficiency and individual freedom • Is addressed by public policy (government) Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-8
  9. 9. Correcting for Externalities • In a pure market system, economic efficiency occurs when individuals know and must bear the true opportunity cost of their actions – In some cases, the price that someone actually pays for a resource, good, or service is higher or lower than the opportunity cost that all society pays Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-9
  10. 10. Correcting for Externalities (cont'd) • Market failure: an example – Assume • No government regulation against pollution • A town with clean air • A steel mill opens and emits smoke that causes – More respiratory diseases – Dirtier clothes, houses, cars Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-10
  11. 11. Correcting for Externalities (cont'd) • Market failure: an example – Market failure occurs • Steel mill does not pay for the clean air • Costs of production have “spilled over” to the residents (third parties) • Lower production cost – More steel is produced than would otherwise be the case Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-11
  12. 12. Correcting for Externalities (cont'd) • Externalities – Occur when the consequences of an economic activity spill over to affect third parties • Third Parties – Parties who are not directly involved in a given activity or transaction • Property Rights – Rights of an owner to use and exchange property Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-12
  13. 13. Correcting for Externalities (cont'd) • Externalities are examples of market failures • Pollution is an example of a negative externality • Inoculations generate external benefits Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-13
  14. 14. Figure 5-1 External Costs and Benefits, Panel (a) Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-14
  15. 15. Figure 5-1 External Costs and Benefits, Panel (b) Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-15
  16. 16. Correcting for Externalities (cont’d) • Resource misallocations of externalities – External costs—market overallocates – External benefits—market underallocates • Government can correct negative externalities – Special taxes (a pollution tax or “effluent fee”) – Regulation Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-16
  17. 17. Example: Hungary’s Tax on Prepackaged Snacks • The Hungarian government has determined that there are external spillovers on the nation’s health care system from the snack food market. • The government wants to discourage production of sweets, salted snacks, and energy drinks. • Therefore, it has imposed a tax on foods with a high content of sugar, salt, carbohydrates, or caffeine. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-17
  18. 18. Correcting for Externalities (cont'd) • How the government can correct positive externalities – Government financing and production – Subsidies – Regulation Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-18
  19. 19. Policy Example: Stop the Presses for Subsidies! • As newspaper readership has declined over the past decade, some government officials have argued that local newspapers provide positive externalities. • They reason that the information provided by newspapers may save lives. • As a consequence, some state governments provide subsidies for local newspapers. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-19
  20. 20. The Other Economic Functions of Government • Providing a legal system • Promoting competition • Providing public goods • Ensuring economy-wide stability Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-20
  21. 21. The Other Economic Functions of Government (cont'd) • Providing a legal system – Enforcing contracts – Defining and protecting property rights – Establishing legal rules of behavior Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-21
  22. 22. The Other Economic Functions of Government (cont'd) • Promoting competition – Market failure may occur if markets are not competitive. • Antitrust legislation • Monopoly power Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-22
  23. 23. The Other Economic Functions of Government (cont'd) • Antitrust Legislation – Laws that restrict the formation of monopolies and regulate certain anticompetitive business practices • Monopoly – A firm that can determine the market price, in the extreme case is the only seller of a good or service Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-23
  24. 24. The Other Economic Functions of Government (cont'd) • Providing public goods – Goods to which the principle of rival consumption does not apply • These are goods that may be consumed jointly by many individuals at the same time. – In contrast, private goods can be consumed by one individual at a time Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-24
  25. 25. The Other Economic Functions of Government (cont'd) • What truly distinguishes public goods from all private goods is that the costs incurred in excluding nonpayers from consuming a public good are prohibitive • Individuals in the private sector have little incentive to provide public goods Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-25
  26. 26. The Other Economic Functions of Government (cont'd) • Characteristics of public goods 1. Can be used by more and more people at no additional opportunity cost 2. Difficult to charge for a public good based on consumption—the exclusion principle Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-26
  27. 27. Example: Private Companies Look to Place Humans in Orbit – and Beyond • Bigelow Aerospace, a private firm, has designed and tested low-cost inflatable space stations in which humans can reside. • Another firm, Moon Express, offers a lowcost method of landing people on the moon. • Other firms are working on the technology to get humans into orbit. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-27
  28. 28. The Other Economic Functions of Government (cont'd) • Free-Rider Problem – Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods – The free-rider problem often emerges in connection with sharing the burden of international defense Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-28
  29. 29. The Other Economic Functions of Government (cont'd) • Ensuring economy-wide stability – Smooth ups and downs in overall business activity – Full Employment Act 1946 • Full employment • Price stability • Economic growth Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-29
  30. 30. The Political Functions of Government • Government-Sponsored Goods – Goods deemed socially desirable through the political process • Museums • Government-Inhibited Goods – Goods deemed socially undesirable • Certain psychoactive drugs Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-30
  31. 31. The Political Functions of Government (cont'd) • Income redistribution: includes progressive income tax system and transfers – Transfer payments – Transfers in kind Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-31
  32. 32. The Political Functions of Government (cont'd) • Transfer Payments – Money payments made by governments to individuals for which in return no services or goods are rendered – Examples are Social Security old age and disability benefits and unemployment insurance benefits Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-32
  33. 33. The Political Functions of Government • Transfers in Kind – Payments that are in the form of goods and services – Include food stamps, subsidized public housing, medical care Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-33
  34. 34. Public Spending and Transfer Programs • Government Outlays – All federal, state and local spending – Examples • Defense, income security, Social Security—at the federal level • Education, health and hospitals, public welfare—at the state level Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-34
  35. 35. Figure 5-2 Total Government Outlays over Time Sources: Facts and Figures on Government Finance, various issues; Economic Indicators, various issues. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-35
  36. 36. Public Spending and Transfer Programs (cont'd) • Publicly subsidized healthcare – Medicare • Began in 1965 • Pays hospital and physicians’ bills for U.S. residents over 65 with public monies • 2.9% of earnings taxed • Second biggest domestic program in existence – Medicaid • Subsidizes people with lower incomes Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-36
  37. 37. Figure 5-3 Federal Government Spending Compared to State and Local Spending Sources: Economic Report of the President, Economic Indicators. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-37
  38. 38. Figure 5-4 The Economic Effects of Medicare Subsidies Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-38
  39. 39. Public Spending and Transfer Programs (cont’d) • To increase the quantity of medical care, the government pays a subsidy – The price per unit paid to medical service providers increases – The price per unit paid by consumers falls – More medical services are consumed Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-39
  40. 40. Policy Example: The Great Underestimates of Health Care Expenses • In 1965, officials estimated the 1990 cost of Medicare to be $12 billion, but the actual program cost in 1990 was $110 billion. • Similarly, the actual $45 billion cost of Medicaid in 1990 far exceeded the initial estimate of $7 billion. • Why were the initial estimates inaccurate? – Congress expanded the number of people eligible for both programs. – Officials did not take into account the fact that the use of medical services would increase once these subsidies were provided. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-40
  41. 41. Public Spending and Transfer Programs (cont’d) • Health Care Subsidies Continue to Grow – The cost of Medicare is now $550 billion per year, and unfunded guarantees of future spending exceed $25 trillion. – In addition, the federal government pays the expenses of Medicaid, a program that provides health care for low-income citizens. – The current cost of Medicaid is more than $400 billion per year. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-41
  42. 42. What If . . . the federal government reduces outof-pocket prices consumers pay for health care services? • If out-of-pocket prices continue to fall, more health care services will be demanded by consumers. • Yet, providers would require higher prices in order to expand the volume of care. • Therefore, higher subsidies would be required, thereby raising the total government outlay. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-42
  43. 43. Public Spending and Transfer Programs (cont’d) • Economic Issues of Public Education – State and local governments provide primary, secondary, and post-secondary education at prices well below those that would otherwise prevail in the marketplace – Publicly subsidized, similar to government subsidized healthcare – Education priced below market Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-43
  44. 44. Public Spending and Transfer Programs (cont’d) • The Incentive Problems of Public Education – Various measures of performance show no increase or decline in performance – Many economists argue failure to improve relies on incentive effects – Higher subsidies may translate to services unrelated to learning Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-44
  45. 45. Example: A Weak Relationship Between Spending and Schooling Results • Alaska, New Jersey, New York, Vermont, and Washington are the states with the highest levels of per-pupil spending in public schools. • The five lowest per-pupil spending states are Arizona, Idaho, Oklahoma, Tennessee, and Utah. • Yet, the educational outcomes do not differ much between these two groups of states. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-45
  46. 46. Collective Decision Making: The Theory of Public Choice • Collective Decision Making – How voters, politicians, and other interested parties act and how these actions influence nonmarket decisions Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-46
  47. 47. Collective Decision Making: The Theory of Public Choice (cont'd) • Theory of Public Choice – The study of collective decision making – Assumes that individuals will act within the political process to maximize their individual (not collective) well-being Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-47
  48. 48. Collective Decision Making: The Theory of Public Choice (cont'd) • Similarities in market and public-sector decision making – Self-interest – Opportunity cost – Competition – Similarity of individuals, but different incentive structures Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-48
  49. 49. Collective Decision Making: The Theory of Public Choice (cont'd) • Incentive Structure – The system of rewards and punishments individuals face with respect to their actions Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-49
  50. 50. Collective Decision Making: The Theory of Public Choice (cont'd) • Differences between market and collective decision making – Government goods at zero price – Use of force – Voting versus spending Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-50
  51. 51. Collective Decision Making: The Theory of Public Choice (cont'd) • Differences between market and collective decision making – Voting versus spending • Political system versus market system – Political system run by majority rule – Market system run by proportional rule Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-51
  52. 52. Collective Decision Making: The Theory of Public Choice (cont'd) • Government or Political Goods – Goods (and services) provided by the public sector • Majority Rule – Collective decision making, decisions based on more than 50% • Proportional Rule – If 10% of “dollar votes” cast for blue cars, 10% of output is blue Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-52
  53. 53. Collective Decision Making: The Theory of Public Choice (cont'd) • Differences between market and collective decision making – Voting versus spending • Spending of dollars can indicate intensity of want • Votes cannot; each vote counts with the same intensity Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-53
  54. 54. You Are There: The U.S. Government Ensures That an Airport is “Convenient” • The free parking, short security lines, and spacious baggage claim areas of the Hagerstown Regional Airport in Maryland make it much more convenient than any major airport. • But this convenience comes at an expense to U.S. taxpayers, who provide a subsidy to finance the operations of Cape Air in providing its daily flights to Baltimore. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-54
  55. 55. Issues & Applications: The GovernmentSponsored U.S. Postal Service • Operating as a government-sponsored enterprise, the U.S. Postal Service (USPS) receives an implicit subsidy in the form of protection from competition. • As mail volumes have declined, postal revenues have fallen short of operating expenses, and federally-provided loans are making up the difference. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-55
  56. 56. Summary Discussion of Learning Objectives • How market failures such as externalities might justify economic functions of government – Market failure is a situation in which an unhindered free market allocates too many or too few resources to a specific economic activity • Private goods versus public goods and the freerider problem – Private goods are subject to rival consumption – Public goods are not subject to rival consumption – Free-riders anticipate others will pay Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-56
  57. 57. Summary Discussion of Learning Objectives (cont'd) • Political functions of government that lead to its involvement in the economy – Merit goods deemed socially desirable – Demerit goods deemed socially undesirable – Redistributing income • Transfer payments • In kind transfers Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-57
  58. 58. Summary Discussion of Learning Objectives (cont'd) • The effect of Medicare on incentives to consume medical services – Subsidies lead to a higher quantity of medical services consumed – Medicare encourages people to consume medical services that are low in per-unit value relative to the cost Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-58
  59. 59. Summary Discussion of Learning Objectives (cont'd) • Why bigger subsidies for public schools do not necessarily translate into improved student performance – Last unit of educational services provided likely to cost more than its valuation by parents and students – Services provided in excess of those best suited to promoting student learning Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-59
  60. 60. Summary Discussion of Learning Objectives (cont'd) • Central elements of the theory of public choice – Collective decision making • Voters, politicians, other participants influence nonmarket choices – Incentive structures • Rewards and punishments affect provision of government goods – Similarities and differences with market system structures • Scarcity, competition—similarities • Legal coercion, majority rule—differences Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-60
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