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This is a complex subject.
First, file formats like avi and mpg should not be confused with codecs. The codec is what determines the size of the resulting clip. You can make very small avis. The codecs that are compatible with avi and mpg are very different and not interchangeable.
If your goal is to make small movies for web or VCD/DVD and you do not plan to get into heavy editing then you should encode directly from the camera into mpg format using a Dazzle DVC II. The reason I recommend this device is because the encoding will be done in real time with the hardware. This device does not support DV or firewire transfers.
If non-linear editing is your bag then go for a DV camera and a DV capture board and use Adobe Premiere.
If you attempt to do software encoding please be aware that the process is painfully slow, it often takes much more than one hour to encode an hour of video.
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