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Econometrics

Attribution Non-Commercial (BY-NC)

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II. Material: Start of Statistical Review: Discrete and continuous random variables Expected value, variance

Random variables: A random variable is any variable whose value cannot be predicted exactly 1. Discrete random variables: Random variable which has a specific (countable set) of possible values Examples? 2. Continuous random variables: Random variable which can take any value of a continuous range of values

red

This sequence provides an example of a discrete random variable. Suppose that you have a red die which, when thrown, takes the numbers from 1 to 6 with equal probability.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

Suppose that you also have a green die that can take the numbers from 1 to 6 with equal probability.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

We will define a random variable X as the sum of the numbers when the dice are thrown.

red green 1 2 3 4 5 6

10

For example, if the red die is 4 and the green one is 6, X is equal to 10.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

If you look at the table, you can see that X can be any of the numbers from 2 to 12.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

We will now define f, the frequencies associated with the possible values of X.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

f 1 2 3 4 5 6 5 4 3 2 1

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

Similarly you can work out the frequencies for all the other values of X.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

f 1 2 3 4 5 6 5 4 3 2 1

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

f 1 2 3 4 5 6 5 4 3 2 1

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

If there is 1/6 probability of obtaining each number on the red die, and the same on the green die, each outcome in the table will occur with 1/36 probability.

Christopher Dougherty 19992006

red green 1 2 3 4 5 6

X 2 3 4 5 6 7 8 9 10 11 12

f 1 2 3 4 5 6 5 4 3 2 1

p 1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36 2/36 1/36

2 3 4 5 6 7

3 4 5 6 7 8

4 5 6 7 8 9

5 6 7 8 9 10

6 7 8 9 10 11

7 8 9 10 11 12

Hence to obtain the probabilities associated with the different values of X, we divide the frequencies by 36.

Christopher Dougherty 19992006

probability

1 36

2 __ 36

3 __ 36

4 __ 36

5 __ 36

6 __ 36

5 __ 36

4 __ 36

3 __ 36

2 __ 36

1 36

9 10

11

12

The distribution is shown graphically. in this example it is symmetrical, highest for X equal to 7 and declining on either side.

Christopher Dougherty 19992006

E ( X ) x1 p1 ... xn pn x i pi

i 1 n

The expected value of a random variable, also known as its population mean, is the weighted average of its possible values, the weights being the probabilities attached to the values.

E ( X ) x1 p1 ... xn pn x i pi

i 1 n

Note that the sum of the probabilities must be unity, so there is no need to divide by the sum of the weights.

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

This sequence shows how the expected value is calculated, first in abstract and then with the random variable defined in the first sequence. We begin by listing the possible values of X.

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1

Then we define a column in which the values are weighted by the corresponding probabilities.

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2

EXPECTED VALUE OF A RANDOM VARIABLE xi x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11 pi p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11 xi pi x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11

Here we are assuming that n, the number of possible values, is equal to 11, but it could be any number.

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X)

The expected value is the sum of the entries in the third column.

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X)

xi

2 3 4 5 6 7 8 9 10 11 12

pi

1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36 2/36 1/36

The random variable X defined in the previous sequence could be any of the integers from 2 to 12 with probabilities as shown.

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X)

xi

2 3 4 5 6 7 8 9 10 11 12

pi

1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36 2/36 1/36

xi pi

2/36

X could be equal to 2 with probability 1/36, so the first entry in the calculation of the expected value is 2/36.

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X)

xi

2 3 4 5 6 7 8 9 10 11 12

pi

1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36 2/36 1/36

xi pi

2/36 6/36

The probability of x being equal to 3 was 2/36, so the second entry is 6/36.

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X)

xi

2 3 4 5 6 7 8 9 10 11 12

pi

1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36 2/36 1/36

xi pi

2/36 6/36 12/36 20/36 30/36 42/36 40/36 36/36 30/36 22/36 12/36

Christopher Dougherty 19992006

xi

x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11

pi

p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11

xi pi

x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X)

xi

2 3 4

pi

1/36 2/36 3/36

xi pi

2/36 6/36 12/36

5

6 7 8

4/36

5/36 6/36 5/36

20/36

30/36 42/36 40/36

9

10 11 12

4/36

3/36 2/36 1/36

36/36

30/36 22/36 12/36

252/36

Christopher Dougherty 19992006

EXPECTED VALUE OF A RANDOM VARIABLE xi x1 x2 x3 x4 x5 x6 x7 x8 x9 x10 x11 pi p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 p11 xi pi x1 p1 x2 p2 x3 p3 x4 p4 x5 p5 x6 p6 x7 p7 x8 p8 x9 p9 x10 p10 x11 p11 S xi pi = E(X) xi

2 3

pi

1/36 2/36

xi pi

2/36 6/36

4

5 6 7

3/36

4/36 5/36 6/36

12/36

20/36 30/36 42/36

8

9 10 11

5/36

4/36 3/36 2/36

40/36

36/36 30/36 22/36

12

1/36

12/36

252/36 = 7

The expected value turns out to be 7. Actually, this was obvious anyway. We saw in the previous sequence that the distribution is symmetrical about 7.

Christopher Dougherty 19992006

Very often the expected value of a random variable is represented by m, the Greek m. If there is more than one random variable, their expected values are differentiated by adding subscripts to m.

E g ( X ) g ( x1 ) p1 ... g ( x n ) pn g ( x i ) pi

i 1 n

To find the expected value of a function of a random variable, you calculate all the possible values of the function, weight them by the corresponding probabilities, and sum the results.

E g ( X ) g ( x1 ) p1 ... g ( x n ) pn g ( x i ) pi

i 1 n

Example:

E ( X ) x p1 ... x pn x i2 pi

2 2 1 2 n i 1 n

For example, the expected value of X2 is found by calculating all its possible values, multiplying them by the corresponding probabilities, and summing.

First you list the possible values of X and the corresponding probabilities.

Christopher Dougherty 19992006

EXPECTED VALUE

xi x1 x2 x3 xn

pi p1 p2 p3 pn

g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn)

Christopher Dougherty 19992006

EXPECTED VALUE OF A FUNCTION OF A RANDOM VARIABLE xi x1 x2 x3 xn pi p1 p2 p3 pn g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn) g(xi ) pi g(x1) p1

Then, one at a time, you weight the value of the function by its corresponding probability.

Christopher Dougherty 19992006

EXPECTED VALUE OF A FUNCTION OF A RANDOM VARIABLE xi x1 x2 x3 xn pi p1 p2 p3 pn g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn) g(xi ) pi g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn

Christopher Dougherty 19992006

EXPECTED VALUE OF A FUNCTION OF A RANDOM VARIABLE xi x1 x2 x3 xn pi p1 p2 p3 pn g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn) g(xi ) pi g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn S g(xi) pi

The sum of the weighted values is the expected value of the function of X.

Christopher Dougherty 19992006

EXPECTED VALUE OF A FUNCTION OF A RANDOM VARIABLE xi x1 x2 x3 xn pi p1 p2 p3 pn g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn) g(xi ) pi g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn S g(xi) pi xi

2 3 4

pi

1/36 2/36 3/36

5

6 7 8

4/36

5/36 6/36 5/36

9

10 11 12

4/36

3/36 2/36 1/36

The process will be illustrated for X2, where X is the random variable defined in the first sequence. The 11 possible values of X and the corresponding probabilities are listed.

Christopher Dougherty 19992006

EXPECTED VALUE OF A FUNCTION OF A RANDOM VARIABLE xi x1 x2 x3 xn pi p1 p2 p3 pn g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn) g(xi ) pi g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn S g(xi) pi xi

2 3 4

pi

1/36 2/36 3/36

xi2

4 9 16

5

6 7 8

4/36

5/36 6/36 5/36

25

36 49 64

9

10 11 12

4/36

3/36 2/36 1/36

81

100 121 144

Christopher Dougherty 19992006

EXPECTED VALUE OF A FUNCTION OF A RANDOM VARIABLE xi x1 x2 x3 xn pi p1 p2 p3 pn g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn) g(xi ) pi g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn S g(xi) pi xi

2 3 4

pi

1/36 2/36 3/36

xi2

4 9 16

xi2 pi

0.11

5

6 7 8

4/36

5/36 6/36 5/36

25

36 49 64

9

10 11 12

4/36

3/36 2/36 1/36

81

100 121 144

The first value is 4, which arises when X is equal to 2. The probability of X being equal to 2 is 1/36, so the weighted function is 4/36, which we shall write in decimal form as 0.11.

Christopher Dougherty 19992006

2

3 4 5

pi

1/36

2/36 3/36 4/36

xi2

4

9 16 25

xi2 pi

0.11

0.50 1.33 2.78

x1 x2 x3 xn

p1 p2 p3 pn

g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn)

g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn S g(xi) pi

6

7 8 9

5/36

6/36 5/36 4/36

36

49 64 81

5.00

8.17 8.89 9.00

10

11 12

3/36

2/36 1/36

100

121 144

8.83

6.72 4.00

Christopher Dougherty 19992006

2 3 4

pi

1/36 2/36 3/36

xi2

4 9 16

xi2 pi

0.11 0.50 1.33

5

6 7 8

4/36

5/36 6/36 5/36

25

36 49 64

2.78

5.00 8.17 8.89

9

10 11 12

4/36

3/36 2/36 1/36

81

100 121 144

9.00

8.83 6.72 4.00

54.83

The expected value of X2 is the sum of its weighted values in the final column. It is equal to 54.83. It is the average value of the figures in the previous column, taking the differing probabilities into account.

Christopher Dougherty 19992006

xi x1 x2 x3 xn

pi p1 p2 p3 pn

g(xi) g(x1) g(x2) g(x3) ... ... ... ... ... ... ... g(xn)

g(xi ) pi g(x1) p1 g(x2) p2 g(x3) p3 ... ... ... ... ... ... ... g(xn) pn S g(xi) pi

xi

2 3 4

pi

1/36 2/36 3/36

xi2

4 9 16

xi2 pi

0.11 0.50 1.33

5

6 7 8

4/36

5/36 6/36 5/36

25

36 49 64

2.78

5.00 8.17 8.89

9

10 11 12

4/36

3/36 2/36 1/36

81

100 121 144

9.00

8.83 6.72 4.00

54.83

Note that E(X2) is not the same thing as E(X), squared. In the previous sequence we saw that E(X) for this example was 7. Its square is 49.

Christopher Dougherty 19992006

E ( X m )2

n

Population variance of X:

E ( X m ) 2 ( x1 m ) 2 p1 ... ( x n m ) 2 pn ( x i m ) 2 pi

i 1

The previous sequence defined the expected value of a function of a random variable X. There is only one function that is of much interest to us, at least initially: the squared deviation from the population mean. The expected value of the squared deviation is known as the population variance of X. It is a measure of the dispersion of the distribution of X about its population mean.

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

We will calculate the population variance of the random variable X defined in the first sequence. We start as usual by listing the possible values of X and the corresponding probabilities.

Christopher Dougherty 19992006

2 3 4 5 6 7 8 9 10

pi

1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36

xi m

5 4 3 2 1 0 1 2 3

(xi m)2

25 16 9 4 1m X 0 1 4 9

(xi m)2 pi

0.69 0.89 0.75 0.44 E( X ) 0.14 0.00 0.14 0.44 0.75

11 12

2/36 1/36

4 5

16 25

0.89 0.69

5.83

Next we need a column giving the deviations of the possible values of X about its population mean. In the second sequence we saw that the population mean of X was 7.

Christopher Dougherty 19992006

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

5.83

Christopher Dougherty 19992006

2 3 4 5 6

pi

1/36 2/36 3/36 4/36 5/36

xi m

5 4 3 2 1

(xi m)2

25 16 9 4 1m X

(xi m)2 pi

0.69 0.89 0.75 0.44 E( X ) 0.14

7 8 9 10 11 12

0 1 2 3 4 5

0 1 4 9 16 25

5.83

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

Next we need a column giving the squared deviations. When X is equal to 2, the squared deviation is 25.

Christopher Dougherty 19992006

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

Now we start weighting the squared deviations by the corresponding probabilities. What do you think the weighted average will be? Have a guess.

Christopher Dougherty 19992006

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

A reason for making an initial guess is that it may help you to identify an arithmetical error, if you make one. If the initial guess and the outcome are very different, that is a warning.

Christopher Dougherty 19992006

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

2 3 4

pi

1/36 2/36 3/36

xi m

5 4 3

(xi m)2

25 16 9

(xi m)2 pi

0.69 0.89 0.75

5 6 7 8 9 10 11 12

2 1 0 1 2 3 4 5

4 1 0 1 4 9 16 25

5.83

Christopher Dougherty 19992006

Population variance of X

E ( X m )2

2 sX

In equations, the population variance of X is usually written sX2, s being the Greek s.

Standard deviation of X

E[( X m )2 ]

sX

The standard deviation of X is the square root of its population variance. Usually written sx, it is an alternative measure of dispersion. It has the same units as X.

probability

1 36

2 __ 36

3 __ 36

4 __ 36

5 __ 36

6 __ 36

5 __ 36

4 __ 36

3 __ 36

2 __ 36

1 36

9 10

11

12

A discrete random variable is one that can take only a finite set of values. The sum of the numbers when two dice are thrown is an example.

Each value has associated with it a finite probability, which you can think of as a packet of probability. The packets sum to unity because the variable must take one of the values.

Christopher Dougherty 19992006

height

55

60

65

70

75

However, most random variables encountered in econometrics are continuous. They can take any one of an infinite set of values defined over a range (or possibly, ranges). As a simple example, take the temperature in a room. We will assume that it can be anywhere from 55 to 75 degrees Fahrenheit with equal probability within the range.

height

55

60

65

70

75

In the case of a continuous random variable, the probability of it being equal to a given finite value (for example, temperature equal to 55.473927) is always infinitesimal. For this reason, you can only talk about the probability of a continuous random variable lying between two given values. The probability is represented graphically as an area.

height

55 56

60

65

70

75

For example, you could measure the probability of the temperature being between 55 and 56, both measured exactly. Given that the temperature lies anywhere between 55 and 75 with equal probability, the probability of it lying between 55 and 56 must be 0.05.

height

0.05

55 56 57

60

65

70

75

height

0.05

55

57 58

60

65

70

75

And similarly for all the other one-degree intervals within the range.

height

0.05

55

57 58

60

65

70

75

The probability per unit interval is 0.05 and accordingly the area of the rectangle representing the probability of the temperature lying in any given unit interval is 0.05.

The probability per unit interval is called the probability density and it is equal to the height of the unit-interval rectangle.

height

0.05

55

57 58

60

65

70

75

Mathematically, the probability density is written as a function of the variable, for example f(X). In this example, f(X) is 0.05 for 55 < X < 75 and it is zero elsewhere.

probability density

f(X)

0.05

55

57 58

60

65

70

75

The vertical axis is given the label probability density, rather than height. f(X) is known as the probability density function and is shown graphically in the diagram as the thick black line.

Christopher Dougherty 19992006

probability density

f(X)

0.05

55

60

65

70

75

Suppose that you wish to calculate the probability of the temperature lying between 65 and 70 degrees. To do this, you should calculate the area under the probability density function between 65 and 70. Typically you have to use the integral calculus to work out the area under a curve, but in this very simple example all you have to do is calculate the area of a rectangle.

Christopher Dougherty 19992006

probability density

5

f(X)

0.05

0.05

0.25

55

60

65

70

75

The height of the rectangle is 0.05 and its width is 5, so its area is 0.25.

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