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A bold move, a calculated risk: Facebook, WhatsApp and game theory

Last week, Facebook announced its decision to buy WhatsApp for $19 billion. HT takes a closer look at the finer nuances of how the bold move was probably guided by a carefully crafted strategy based on principles of game theory.

business Updated: Feb 26, 2014 00:48 IST
Gaurav Choudhury
Gaurav Choudhury
Hindustan Times
Facebook,WhatsApp,Facebook buys WhatsApp

Last week, social networking giant Facebook announced its decision to buy WhatsApp, a peer-to-peer messaging service linked through mobile numbers, for $19 billion (about Rs. 1,18,000 crore). HT takes a closer look at the finer nuances of how the bold move was probably guided by a carefully crafted strategy based on principles of game theory:

What does Facebook’s acquisition of WhatsApp mean for the buyer?
Facebook’s decision to buy WhatsApp for such a high price was probably based on its plans to make the next big venture into the mobile Internet arena, billed as the next big thing in the realm of social networking. WhatsApp, and some of its peers, could eventually make SMS dated. For Facebook, it was critical to embrace the emerging group messaging culture that is fast changing the grammar of social media communication. The deal brings on WhatsApp’s 450 million subscribers, of which 10% are in India, to its fold, enabling its immediate expansion as an on-the-move network from mostly desktops and smartphones.

Why did Facebook agree to pay such an expensive price for this purchase?
Facebook’s strategy was simple: price out rivals. There are now reports that Internet giant Google was also in active discussions to buy out WhatsApp. Initial reports had claimed that Google had bid $10 billion for the company, just about half of the amount Facebook offered. Later reports suggest that Google upped its offer for WhatsApp after it learned how much Facebook would eventually pay the messaging service. It is an example of a game theoretic exercise, where firms try to outthink each other.

Read: Is Facebook's $19 billion price tag for WhatsApp justified?

What is game theory?
Game theory is a branch of mathematical economics first theorised by Jon Von Neumann in the 1930s. It involves the principles of probability in a multi-player world where each player (agent, firm) attaches a certain probability to the other players’ behaviour to an action he himself undertakes.

How does it work?
Game theory is best explained in the context of auctions. An auction is a non-cooperative game involving several players. Each player assumes that the other players would react in a certain way for every action of his. The strategies and tactics are based on this assumption. In mathematics, these are called as “mixed probabilities”. Facebook’s final price offer was based on a probability it had assigned about what other potential bidders — such as Google — may be willing to offer for WhatsApp. Likewise, Google’s reported $10 billion offer was also based on what it thought was probable for a competitor to offer.

Read: Facebook-WhatsApp most expensive deal, other big buys

Are there any specific examples involving Indian companies that can be cited that have used game theoretic tools?
Yes. The acquisition of a European steel maker by an Indian company (Tata Steel) in 2007 reflects the principles of a non-cooperative game theoretic strategy. After the bids were submitted, both the Indian company and its rival, a South American firm, were asked to participate in an auction to bag ownership of the target company. As the auction reached the ninth round, the Indian company announced the tactic saying that it would bid five pence more than whatever the South American rival bids. The strategy was based on the probability that the South American company would not bid beyond the certain point as the Indian company’s bid would anyway be higher by five pence than its rival’s. This move was based on the assumption that the probability of the rival continuing to bid beyond a certain level would be negligible. It turned out as planned.

What is Prisoner’s Dilemma?
Nash equilibrium, named after John Nash, Nobel prize winner and whose life the Oscar winning flick A Beautiful Mind was based, is the solution to ‘game’ where each player thinks about his best strategy irrespective of what others would be doing. Nash used a situation called the “Prisoner’s Dilemma” to students of psychology explaining the concept, where in a closed cell, a prisoner would rather seek to maximise his gains than to “cooperate”.

Read: HT Column | WhatsApp buyout will tighten Facebook's grip on India

First Published: Feb 26, 2014 00:39 IST