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When using iA+ mode on my Panasonic G3 something called iDynamic kicks in and preserves the highlights in the image. I wonder how this is possible, and not just a part of the dynamic range of the sensor. What is the downside to this regarding image quality?

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Almost all these systems work in a similar way, be it iDynamic (Panasonic), DRO (Sony), Adaptive D-Lighting (Nikon), HTP (Canon), etc.

What they do is adjust the exposure so that to capture more details in the highlights. This causes under-exposure in the shadow areas which the camera compensates for by boosting levels there which reveals the downside of using this: increased noise in shadow areas as a result of this processing.

This is better than doing it yourself on JPEG images because it is done at RAW bit-depths prior to demosaicing. If you shoot RAW instead you can do this yourself in the conversion step which of course is more work for you. Note that because the exposure is adjusted, enabling this affects RAW on most cameras.

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