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Up to this point, because I didn't know better, I've done my image post-processing in 8-bit mode. What does this mean, and how does it affect the quality of the image? What software do I need to edit in a 16-bit workspace? Here are the results of my investigation of these questions...

Bit depth

Apparently most digital cameras (and scanners) use 12-bit analog to digital converters, giving you the potential of 12-bits per channel raw (various proprietary formats e.g. NEF), 8-bit JPEG, or 8 or 12-bit TIFF as a starting point. Software for image editing, like Photoshop, can work in 8-bit or 16-bit mode. You print or save for online viewing as JPEG using 8 bits per channel (24-bit colour). More bits equals more image data:

8 bits produce 256 tones; 3 channels = 24-bit image
12 bits produce 4096 tones; 3 channels = 36-bit image
16 bits produce 65,536 tones; 3 channels = 48-bit image

Bottom line: We want to start out with as much image data as possible, so shoot raw if possible.

Raw conversion

Adobe Camera raw gives you the option of opening your converter image in an 8-bit or 16-bit workspace. More details here.

Bottom line: We want to minimise image degradation during the editing process, so open images a 16-bit workspace.

Editing in a 16-bit workspace

Opening a 12-bit raw file in an 8-bit workspace involves some loss of data as there are fewer bits to contain data describing tones etc, as the data are effectively rounded to fit into a smaller space. This also means further editing visibly degrades the image each time it is re-saved.

Opening a 12-bit raw file in a 16-bit workspace means we start out with all our original image data, and still have "room" to make edits that are much less likely to have a visible effect on the image. Bob Johnson from Earthbound Light offers an important qualification:

Does all this mean my image will never get damaged if I always keep it in 16-bit mode? Unfortunately, no, but it does greatly lower the possibility of damage that will show. There really is only so much you can do to an image, and Photoshop should not be viewed as a substitute for getting it right in the field. Push your pixels around too much and you will eventually have problems no matter what. 16-bit editing allows you to do reasonable edits to optimize an image, but it won't let you turn a bad image into a good one.

A heavily-manipulated image can be spotted by looking at its histogram. Instead of a smooth transition between tones, a "comb-like" type of histogram can reflect obvious changes in tone from one pixel to the next, an appearance called "posterization". Even common, simple manipulations like levels adjustment or contrast enhancement can be degrading. For example, here is the histogram of a raw image opened in a 16-bit workspace, prior to post-processing:

Here is the histogram for the same image, with auto levels, contrast, and colour applied in 16-bit mode, followed by conversion to 8-bit mode for saving as a JPEG:

The curve still looks smooth. Here is the histogram for the same image, with auto levels, contrast, and colour applied in 8-bit mode, followed by saving as a JPEG:

Notice the curve isn't as smooth? The more extensive the manipulation, the more exaggerated the spiking/ comb effect. If you're not quite clear about the comb analogy, here is an artefact from Chester's Fort (Hardian's Wall, UK) that literally has "bits missing". You know it's a comb, but the gaps mean you can't recover what's not there:

Tip: If your camera doesn't do raw, but can save a high-quality JPEG and you plan do do some post-processing, open your JPEG in Photoshop and change to 16-bit mode for all your editing. Once done editing, save as an 8-bit JPEG. Doing this will minimise image degradation.

What software?

As I own Photoshop 7 and Photoshop Elements 3, I downloaded the trial version of Photoshop CS2 and compared the capabilities of each program in both 8-bit and 16-bit mode, using my usual workflow. I have ignored custom Actions (e.g. to correct barrel distortion). Here's how they stack up:

Notes:

1. Via Filters (Distort > Lens Correction)
2. Via Adjustments menu
3. Via Spot Healing Brush (no need to option-click)
4. Via Tools
5. Via Filters (Noise > Reduce Noise)
6. Via Smart Sharpen (cf. Unsharp Mask)
7. Automatic only (no Curves adjustment)
8. Via the middle dropper tool in the Levels dialog

Conclusion

By prioritising 16-bit mode edits in PSE (then converting to an 8-bit workspace), you can achieve most of the functionality of PS CS2 and minimise image degradation. PS 7 is really only useful for utilising the Healing Brush in 16-bit mode. However, in terms of a streamlined workflow CS2 does it all—especially if you count the extra options available during raw conversion.

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