As we have seen before factor abundance leads to comparative advantage. Perhaps this theory overlooks an important point. When factors are abundant, it might lead to inefficient use of that factor as there is little incentive to use this factor in an efficient way. If factors are scarce, firms have a strong incentive to make efficient use of the available resources, and be innovative. There are numerous examples of cases where scarcity has led to innovation. Japan’s scarcity of land has delivered us the just-in-time production. In the North Sea, oil platforms are expensive to build and maintain; their scarcity has led to the development of horizontal drilling to reach distant under-sea oil reservoirs. Short building seasons in Sweden have led to prefabricated houses. Michael Porter is an very famous Harward professor who is especially well known with the theory of nations competitive advantage.According to the Porter the standard and classical theories on comparative advantage are wrong. Michael Porter (1990) proposed a model that provides conditions that have to be met for a firm to be internationally competitive and successful. He believes that a nation attains a competitive advantage if its firms are competitive. Firms become competitive through innovation. Innovation can include technical improvements to the product or to the production.
This model focuses on four primary conditions which he arranged in a diamond-shaped diagram (hence the name “Porter’s diamond”). These four key elements to international entrepreneurial success are:
a. factor conditions (i.e. the nation’s position in factors of production, such as skilled labour and infrastructure),
b. demand conditions (i.e. sophisticated customers in home market),
c. related and supporting industries, and
d. firm strategy, structure and rivalry (i.e. conditions for organization of companies, and the nature of domestic rivalry).
e.
Figure 1
a. Factor Conditions
• Factor conditions refers to inputs used as factors of production – such as labour, land, natural resources, capital and infrastructure. This sounds similar to standard economic theory, but Porter argues that the “key” factors of production (or specialized factors) are created, not inherited. Specialized factors of production are skilled labour, capital and infrastructure.
• “Non-key” factors or general use factors, such as unskilled labour and raw materials, can be obtained by any company and, hence, do not generate sustained competitive advantage. However, specialized factors involve heavy, sustained investment. They are more difficult to duplicate. This leads to a competitive advantage, because if other firms cannot easily duplicate these factors, they are valuable.
• Porter argues that a lack of resources often actually helps countries to become competitive (call it selected factor disadvantage). Abundance generates waste and scarcity generates an innovative mindset. Such countries are forced to innovate to overcome their problem of scarce resources.
i. Switzerland was the first country to experience labour shortages. They abandoned labour-intensive watches and concentrated on innovative/high-end watches.
ii. Japan has high priced land and so its factory space is at a premium. This lead to just-in-time inventory techniques (Japanese firms can’t have a lot of stock taking up space, so to cope with the potential of not have goods around when they need it, they innovated traditional inventory techniques).
iii. Sweden has a short building season and high construction costs. These two things combined created a need for pre-fabricated houses.
b. Demand Conditions
• Porter argues that a sophisticated domestic market is an important element to producing competitiveness. Firms that face a sophisticated domestic market are likely to sell superior products because the market demands high quality and a close proximity to such consumers enables the firm to better understand the needs and desires of the customers (this same argument can be used to explain the first stage of the IPLC theory when a product is just initially being developed and after it has been perfected, it doesn’t have to be so close to the discriminating consumers).
• If the nation’s discriminating values spread to other countries, then the local firms will be competitive in the global market.
c. Related and Supporting Industries
• Porter also argues that a set of strong related and supporting industries is important to the competitiveness of firms. This includes suppliers and related industries. This usually occurs at a regional level as opposed to a national level. Examples include Silicon valley in the U.S., Detroit (for the auto industry) and Italy (leather-shoes-other leather goods industry).
• The phenomenon of competitors (and upstream and/or downstream industries) locating in the same area is known as clustering or agglomeration. What are the advantages and disadvantages of locating within a cluster? Some advantages to locating close to your rivals may be
i. potential technology knowledge spillovers,
ii. an association of a region on the part of consumers with a product and high quality and therefore some market power, or
iii. an association of a region on the part of applicable labour force.
• Some disadvantages to locating close to your rivals are
i. potential poaching of your employees by rival companies and
ii. obvious increase in competition possibly decreasing mark-ups.
d. Firm Strategy, Structure and Rivalry
1. Strategy
(a) Capital Markets
o Domestic capital markets affect the strategy of firms. Some countries’ capital markets have a long-run outlook, while others have a short-run outlook. Industries vary in how long the long-run is. Countries with a short-run outlook (like the U.S.) will tend to be more competitive in industries where investment is short-term (like the computer industry). Countries with a long run outlook (like Switzerland) will tend to be more competitive in industries where investment is long term (like the pharmaceutical industry).
(b) Individuals’ Career Choices
o Individuals base their career decisions on opportunities and prestige. A country will be competitive in an industry whose key personnel hold positions that are considered prestigious.
o Does this appear to hold in the U.S. and Canada? What are the most prestigious occupations? What about Asia? What about developing countries?
2. Structure
• Porter argues that the best management styles vary among industries. Some countries may be oriented toward a particular style of management. Those countries will tend to be more competitive in industries for which that style of management is suited.
• For example, Germany tends to have hierarchical management structures composed of managers with strong technical backgrounds and Italy has smaller, family-run firms.
3. Rivalry
• Porter argues that intense competition spurs innovation. Competition is particularly fierce in Japan, where many companies compete vigorously in most industries.
• International competition is not as intense and motivating. With international competition, there are enough differences between companies and their environments to provide handy excuses to managers who were outperformed by their competitors.
These four attributes, factor conditions, demand conditions, related and supporting industries, and firm strategy, structure, and rivalry, are what Porter calls the “Diamond of National Competitive Advantage”. The top ten companies listed in Fortune’s article as being America’s Most Admired, Coca-Cola, Mirage Resorts, Merck, United Parcel Service, Microsoft, Johnson & Johnson, Intel, Pfizer, Procter and Gamble, and Berkshire Hathaway, are all in highly competitive industries. Porter’s assessment that “America does well in relatively new industries, like software and biotechnology, or ones where equity funding of new companies feeds active domestic rivalry, like specialty electronics and services” describes most of the aforementioned companies And, because of their recognition and the fact that Americans are one of the “world’s most sophisticated and demanding buyers” in these industries, these companies should have the drive to continuously innovate Since the companies are all relatively large and in industries where there are a lot of related and supporting industries, another part of Porter’s “Diamond of National Competitive Advantage” is filled. To be innovative, these companies must have good firm strategies and structure. The most admired company since 1995, Coca-Cola has received praise “for its financial soundness, management quality, and investment value”
Figure 2
So, America’s national competitiveness depends partly on these companies and on new industries. Government’s role is important in varying degrees in the successes of the top ten most admired companies of 1996 and other companies and perhaps government played a role in the failures of others. Porter’s description of national advantage is sufficient but he should emphasize the fact that although local rivalry is still an important factor, a world of global competition requires rivals are to be watched in any country. Increasingly, companies located in one country will have more innovations coming from subsidiaries in other nations. No matter what nation is considered, though, all companies and governments, must continuously innovate. Why? Innovation breeds prosperity.
Competitive Advantage introduces a powerful tool that the strategist needs in order to diagnose and enhance competitive advantage: the value chain. Value chain analysis allows the manager to separate the underlying activities a firm performs in designing, producing, marketing, and distributing its product or service. It is these activities from which competitive advantage ultimately stems. By showing how all the firm’s activities can be examined in the integrated way, Porter provides a new and practical perspective on competitive strategy.
Using value chain analysis, Porter shows:
How to understand the behavior of costs, and how to create and sustain a cost advantage
How to identify what creates value for the buyer and hence differentiation, and how to carry out a successful differentiation strategy
How to choose a technological strategy that reflects the significance of the firm’s technologies for competitive advantage as well as the benefits and costs of being a technological leader
How to improve a firm’s competitive position by identifying “good” and “bad” competitors, and to decide what market share and mix of competitors optimizes long-term profitability
How to segment an industry, and formulate profitable and sustainable focus strategies based on that segmentation
How to create competitive advantage through corporate strategy by harnessing interrelationships among related industries
How to manage a diversified firm so that the resistance to achieving strategic interrelationships among business units can be overcome
How to cope with strategic uncertainty, using industry scenarios to illuminate the range of possible future competitive environments
How to defend a firm’s competitive position when challenged, and how and when to attack an industry leader.
There are two basic types of competitive advantage: lower cost and differentiation.
Lower cost is the ability of a firm to design, produce, and market a
comparable product more efficiently than its competitors…Differentiation is the ability to provide unique and superior value to the buyer in terms of product quality, special features, or after-sale service.[ix]
One of the most obvious competitive advantages that developing nations enjoy is the ability to achieve lower production costs by paying workers lower wages (relative to developed nations). This advantage can be attributed mainly to the inflated wages that labor unions have secured for workers across various industries in the developed world. For example, the United Auto Workers union cites figures from the Bureau of Labor Statistics (BLS) showing that the wages and benefits of union workers in the United States are 33 percent higher than their non-union American counterparts. It is not surprising then, that workers in Mexico, Brazil, and South Korea can be hired at 10 to 15 percent of the average American wage, while “auto workers in Illinois earned in a day or two what the electronics workers of Malaysia earned in a month. The ability to pay competitive wages in a competitive labor market is precisely the competitive advantage that developing nations have employed in efforts to become more efficient producers. However, not everyone endorses such a practice.
Although economic theory supports the realization of competitive advantage through wage differentials, there remains considerable debate over what is an appropriate wage. One organization, the International Centre for Human Rights and Democratic Development, even goes so far as to equate wages in Asia with human rights, asking, “to what extent are low wages and unacceptable health and safety standards of the region due not only to lower levels of economic development but also to the fact that labour doesn’t enjoy basic human rights?
” Perhaps this organization needs to be reminded that the “low wage” earners it claims to protect have freely chosen to work in democratic, free-market economies in exchange for competitive, market wages. They are not forced to work. But they do work, and they do accept the competitive wage. The working paper cited above criticizes the labor practices of several developing nations in Asia including Malaysia, which is labelled as “anti-labour,” and is criticized for “uncontrolled urbanization.” Once again, perhaps this organization needs to be reminded that from 1971 to 1991, Malaysia’s economy maintained a steady growth rate of seven percent per year, per capita income rose from US$410 per year to $3000 per year, and life expectancy increased from 62.3 to 70.5 years.Wages in Malaysia may be low by U.S. standards, but nonetheless, they have proven high enough to sustain economic growth and support a higher standard of living.
In addition to addressing the “low labor cost” benefits of competitive advantage more explicitly, the WTO also needs to address another area of competitive advantage. Recall Porter’s two types of competitive advantage: low cost and differentiation. Differentiation is “the ability to provide unique and superior value to the buyer in terms of product quality, special features, or after-sale service.Traditional economics purports that as competition in a given industry increases, differentiation and innovation will naturally follow, as firms compete for the leading share of the market. However, it is important to recognize that even in a free-trade environment of most-favoured nation status, non-discrimination, and bound tariffs, competition may still be threatened by collusive arrangements between large transnational corporations (TNCs) who seek to monopolize (or more accurately, “oligopolize”) international markets by forming global cartels. According to the United Nations Centre on Transnational Corporations.
THE GOVERMENT’S ROLE :
The government plays an important role in Porter’s diamond model. Governments can influence all four of Porter’s determinants through a variety of actions such as
• Subsidies to firms, directly (moeny) or indirectly (infrastructure)
• Tax code as applicable to firms (corporate income tax, ancillary business and property taxes)
• Regulation and deregulation of capital markets and foreign exchange controls
• Education policies that affect the skill level of workers
• Establishment of technical standards and product standards, including environmental regulations
• The government’s purchase of goods and services
• Antitrust regulation
For example in India,the textile industry makes an enormous and multi-directional contribution to the domestic economy. The industry accounts for nearly 20% of the total national industrial production and provides employment to over 15 million people. It also accounts for more than 30% of exports, making it India’s largest net foreign exchange industry (Dalmia, 1994). In addition, India’s economic situation has improved dramatically since the Indian government introduced new economic reforms in 1991, leading to liberalization in government policies and a significant increase in its foreign exchange reserve position.
Moreover, Porter has emphasized the role of chance in the model. Random events can either benefit or harm a firm’s competitive position. Typically, such events are
• Major technological breakthroughs or inventions.
• Political decisions by foreign governments.
• Acts of war and destruction.
• Dramatic shifts in exchange rates.
• Sudden price shocks affecting input goods (such as the oil price shock in the early 70s)
• Sudden surges or drops in world demand or sudden shifts in consumer preferences.
INTERNATIOANAL COMPETITIVENES OF U.S. WINE INDUSTRY :
Wine production, sales, and consumption in the United States are growing. Competition in this growing market involves product differentiation. In the US wine industry, firms attempt to differentiate themselves in two main ways. First, in response to competition, both foreign and domestic, there are continuous changes to the product. In fact, the wine’s chemistry may be little changed; the marketing and the tale surrounding the wine changes to modify consumer preferences toward the wine. Also, wineries may offer wine in different wine segments, thus changing the competitive forces on their brand. Many smaller wineries offer products that cater to those looking for a low-price wine and for those seeking a good value with excellent quality.
This further differentiates the winery’s product, allowing their competitive advantage to step to the foreground. Michael Porter speaks of “competitive advantage” as the way firms use their inherent advantages to compete. This is not necessarily in terms of costs, but how the firm adds value through specific functions. The way value-added activities are measured and compared to their competitors is through Porter’s value chain. This study involves a look at the US wine industry through some comparative statistics, and attempts to identify the nature of its competitive advantage. We claim that the quality perception is a major part of these advantages, especially in higher-priced segments. The nature of Chilean competition is discussed to give an insight as to Chile’s ability, or lack thereof, to penetrate US wine markets.
The United States is arguably the best place to grow grapes in the world. Two fundamental economic reasons lead to this possibility. First, the United States boasts world-famous growing areas that rival France and Italy in quantity produced and in quality of wine, as the technology and weather are extremely similar. The growth in US wine sales has been strong over the past five years. Its growth has been, according to industry leaders and experts, the result of higher demand, better marketing campaigns, and a concentration on quality.
Percentage Change in Wine Sales
Figure 3
Porter’s idea that a firm finds advantages in niching through many different ways allows a great deal of flexibility for managers and policy makers in budgeting, forecasting, and planning for future developments. The firm’s ability to compete depends on how it can compete. A firm’s prosperity is created, not inherited. In the true capitalist sense, firms must constantly seek the parts of their enterprises that function at a more efficient level than in competing firms. All firms that survive must have some attribute that leads to cost advantages. This is the basis of comparative advantage, the theory of international trade predicated on a country being the low-cost provider of a good to export the good in net. In a similar way, competitive advantage claims that firms inherently strive to focus their output using a mix of their low-cost segments such that the sum of these segments, the value chain, delivers the maximum profit possible for the firm.
The economic ideas of competitive advantage derive from industrial organization theory (IO). IO suggests that firms will act and react depending on how their competitors act and react to them. This “interdependence” is the cornerstone of IO, as its implications reach all decisions of the core business leaders in the firms and the industry. Pricing, new products, segmentation, niching all depend on how competitors react in the industry. If competitors react in such a way that buyers see a better value in the competing good, the firm loses market share. The firm gains competitive advantage through two sources. First, the firm uses overall cost leadership to obtain some basic advantages over rival firms. The second way is through differentiation. The firm uses new techniques, new products, and new ideas in an attempt to become more competitive or profitable. Let us not forget the economic foundations of this analysis. The firm, if rational, is still striving for the maximization of profit. It is my belief that the California wine industry is dominated by its drive to differentiate, and seeking low-cost alternatives is not as important. Many nations havepenetrated these markets by differentiating themselves. As competition rises, each firm and country mocks each other’s movement in an attempt to gain market share. This is where competitive and comparative advantage intersect.
Hypotheses Concerning Competitive Advantage
1. The price elasticity of demand for wine is greater than one in absolute value, implying relative substitutability in wines and producer homogenity in the eyes of the consumer.
2. The cross-elasticity of demand between Chilean wines and US wines is greater than 0, defining them as substitutable goods.
3. The tasting-score elasticity of demand is greater than zero, implying that as the tasting score of the wine increases, the demand for wine increases.
4. The foreign tasting-score elasticity of demand is less than zero, implying that as the tasting score of the Chilean wine increases, the demand for the wine increases.
5. The consumption elasticity of demand is greater than zero, implying that as consumption increases, the demand for wine increases. This further implies that as income increases, wine consumption increases.
These elasticities are easily estimated through an econometric model, a linear regression where the US demand for wine is based on the inverse demand function above.
In a forthcoming study, historical data will be used to test these hypotheses. Tasting scores are difficult to find for older vintages, but a cross-section analysis somewhat defeats these problems. More research in this area is needed.
About Value Chain
The methods to look at industries via a value-chain use the basic devices of microeconomics to analyze the firm. Firms are rated in terms of their advantages, as weighted in many different categories. The weightings take place through separating firms into Strategic Business Units (SBUs) such that all the firm’s activities are assigned a category and specific function. Competitive advantage takes place when a firm has differentiation in activities such that they do that activity better than any other competing firm. This leads to cost advantages, and overall better competitiveness, much like comparative advantage in international trade.
Competitive advantage promises profits if the firm differentiates itself adequately. Through competitive advantage, a firm finds ways to compete through niching in activities rather than final products. Standard microeconomic theory places product differentiation at the core of how firms differ themselves from very close substitute goods and firms. Porter (1985) implies that through profitable activities, comparative advantage in the industry (competitive advantage) can be struck and held. Porter also defines these categories as shown below.
Primary Activities. In the examination of competitive advantage, we focus on primary activities. These activities are the cornerstone of the production and distribution processes in the firm. In the context of a US winery, these activities are centered on the acquisition of the fruit and the fruit’s use in the winemaking process.
1. Inbound Logistics. These activities begin with the fruit itself. The importance of receiving the fruit as a function of a winery depends on being an estate winery (a winery that produces some wine from fruit that are grown on the premises) or a winery that must procure all its fruit from outside sources. If the latter, the fruit must be delivered to the production facility, if that facility is on the grounds where the bottling and storage takes place, and must be immediately prepared for the wine-making process. If the fruit comes to the winery, and no estate fruit is used or available, then the labor and vineyard management positions are not part of the winery’s primary activities. We claim below that those wineries that produce no indigenous fruit and wine use these activities as support activities rather than primary endeavors.
2. Operations. Once wine has arrived at the production facility, the operations end of wine begins.
3. Outbound logistics. The size of the winery dictates the sales force breadth of the firm.Two important aspects of the winery’s distribution choices include choice of markets and lot size. Regardless of the number of cases produced by the winery, the wine’s distribution is a major part of the firm’s overall image. If the winery’s market is high-end dining establishments, and not grocery stores, the wine competes with different wines, foods, and beverages. In this sense, if the tasting scores and marketing are important to the firm, the segment choice and the amount to be sold per customer in that market may have an influence on the firm’s overall image. This image is the key to the marketing scheme of the firm.
4. Marketing and Sales: The most significant change in the wine industry concerning marketing is the new focus on the complimentarity between food and wine.
The latest challenge to the marketing of US wine is the changing demographics of wine drinkers. This is where Chilean and Australian wines have influenced pricing and marketing campaigns. Many wineries and wine organizations were attracted to the high prices and the upper-class clientele that came with it. This left many soon-to-be wine drinkers associating wine with their parents, the upper-class, and not with a good time. Beer has dominated the younger drinkers’ consumption habits. Certain US consumer groups formed specifically to help the wine industry make this transition in marketing campaigns to focus on those under 30 years of age. How the wineries attack this problem in the future remains to be seen, but its presence has forced every winery, regardless of size to be cognizant of how certain competitors may try and differentiate such that the younger market is established. It is to be a great challenge.
5. Service. Few wineries engage in long-term, service relationships with their customers. In many cases, the wineries establish strategic alliance with certain restaurants and distributors such that post-sale services are part of the transaction. Because of the perishability of wine, and the fact that the storage of wine is very important to its quality, certain wineries set up delivery, storage, and spoilage instructions and warranties.
Support Activities. Any activities called support act as a complement to the primary activities above. While the image of the winery is built and maintained above, the support activities help the winery guide day-to-day functions as a firm, and encompass many of the roles that are not wine-specific. In many cases, California’s firms combine support and primary functions. These are not the main ways the firm differentiates its product, nor gains access to comparative advantage. These are, however, the activities that protect the firm from losing its comparative advantage once established.
1. Procurement. For most California wineries, the procurement processes are divided into three distinct groups. For buying the grapes, barrels, labor, and direct production inputs (labor, land, capital, entrepreneurs), the owner and CEO play a direct role. The winemaker also participates in fruit procurement, as it is the key input for the winemaking process. In certain wineries, the winemaker and the vineyard manager control the purchasing of the grapes, labor, and storage units. The second group deals with the office supplies and the basic technology for running the winery as a firm. This includes goods such as paper, copiers, computers, pencils, telephones, utility services, etc. In the average winery, the office manager, or the person who runs the business functions of the winery purchases these goods. The third group includes the tasting room, if one exists.
2. Technology Development. Technology enters the winery in two key ways. First, the winemaking process may become more mechanized, involving the winemaker in new capital and new techniques. In other cases, the changes in technology do not affect the winemaking process at all; if the winemaking takes place in a archaic fashion, technological changes do not affect the firm. In some cases, the winemaking style, especially if it is a labor-intensive, hands-on process, may become part of the winery’s marketing scheme.
The other key area for technology at wineries is in microcomputing. The accounting, inventory, and marketing functions are now computerized at most California wineries. Productivity in these positions: office workers, bookkeepers, etc., should be augmented the faster and more proficient the computer software. With the increase in the use of the internet, many wineries have websites, links, and internet sales. If the winery has technology support, it normally is a consulting position. In certain cases, California wineries employ an individual that has computer skills.
3. Human Resource Management. The tasting room manager normally oversees all hires inside the tasting room. The president/CEO oversees other administrative hires. All field hires, if an estate vineyard is owned, are through the vineyard manager, while all cellar hires are made by the winemaker. Thus the chain of command at a winery can be somewhat disaggregated. If their is a sole owner, the owner may want input on administrative hiring, but certainly allows the field and cellar labor to be hired ultimately by those not directly involved in that position.
4. Firm Infrastructure. The firm infrastructure ranges from incredibly nuclear to peripheral. In some cases, especially larger wineries, the accounting, legal, public relations function may take place internally. In smaller wineries, they may choose to subcontract this labor out, allowing for some administrative cost increases, but not provide the on-site infrastructure of more office space. Many firms fulfill these needs for smaller wineries, specializing in wine accounting, legal matters for wineries, and public relations. The type of infrastructure is normally a function of size, as larger wineries can absorb more fixed costs to keep a lawyer and accountant; however, regardless of size, most wineries have at least a public relations director, any may use some outside help for larger jobs.
Conclusions.
The California wine industry mixes the best and worst characteristics of the US wine industry. There are spectacular producers, winning global accolades for their wine, and selling their entire production years in advance. There are other producers that are in the industry for bulk purposes, and provide large volumes of lower-quality wine. We saw above that Chile is a possible competitor for these firms, especially in the way they are niching in the pop-premium and premium wine segments. California’s firms must recognize the threat, and adjust their marketing, public relations, pricing, and varietal choices as to protect their competitive advantage. The key, according to Michael Porter’s writings, to controlling one’s market share is through competitive advantage. Product differentiation and maintaining low costs lead to this advantage. With changing consumer demographics and international competition, California’s wineries are great examples of dynamic firms in a dynamic market searching for a strategic plan.
CRITICISMS OF PORTER’S MODEL :
The Porter model has been criticized on the following points:
1. It focuses too strongly on developed economies.
2. The government’s role can be both positive and negative. Even well-intentioned government actions can occasionally fail by cushioning domestic industries and making them less internationally competitive.
3. Chance is difficult to predict. Situations can change very quickly and unexpectedly.
4. Porter says, that “firms, not nations, compete in international markets”. This means that by focusing on national comparative advantage must be understood on a firm level rather than a cuntry level.
5. Porter describes four distinct stages of national competive development
1. Factor-driven (e.g., Singapore)
2. Investment-driven (e.g., Korea)
3. Innovation-driven (e.g, Japan, Italy, Sweden)
4. Wealth-driven (e.g., Great Britain, with the U.S. and Germany between innovation-driven and wealth-driven), characterized by decline.
6. Porter argues that only outward-FDI is valuable in creating competitive advantage, and inbound-FDI does not increase domestic competition significantly because the domestic firms lack the capability to defend their own markets and face a process of market-share erosion and decline. However, there seems to be little empirical evidence to support that claim.
7. Porter contends that reliance on natural resources alone is insufficient. Canada is an example that doesn’t fit this description, as is apparent by the success of Canadian MNEs like Alcan and Norando.
8. The Porter model does not adequately address the role of MNEs. There seems to be ample evidence that the diamond is influenced by factors outside the home country.
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