I think the lesson here is that you don't necessarily have to compete with the big boy's entire site. You "just" have to zero in on one aspect of their site and threaten their positive image in that area. In this case, Facebook apparently felt their album feature is inadequate and that Instagram could become a problem for them down the road.
Let's not forget that MySpace bought Photobucket for $250 Million. This really isn't any different than Facebook buying Instagram.
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