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The Microhoo! deal is all about network effects

Although most corporate mergers fail (often due to mis-aligned incentives on the part of the deal-makers) there is a solid economic foundation for the proposed Microsoft + Yahoo! merger.  Most of their assets will work no better combined than separate.  But the merged Microhoo ad network would be significantly more valuable than the sum of two ad networks alone

Why bigger is better for online advertisers

The reason lies in network effects of the online search + advertising industry.  Imagine you’re an ad buyer which is to say you have a service you want consumers to find online.  Unless you’re a huge company, you have limited energy to expend buying your ads.  So rather than buying and managing separate ads from each Microsoft, Google and Yahoo, you’re likely to just deal with a single ad publisher.  The sensible ad buyer will choose the ad publisher which gives them the most value for limited effort. 

Right now the clear choice for an online advertiser is Google.  Because they have the most search traffic, they are best able to reach customers.  Combined with their adsense network, Google clearly has the largest inventory for an ad buy making them the natural choice for anybody not willing to spend a lot of energy managing their online advertising.  This logic underlies the recent acquisitions of Doubleclick, AvenueA/Razorfish/whomever, and now Yahoo!  Network effects in advertising mean that the largest network will be the most sucessful.  So the mergers will continue as far as the anti-trust regulators allow them to until a handful of bitter enemies remain.

This much might be obvious to some of my readers.  But I felt like sharing this analysis since I’ve read nothing in the common press that explains the basic economic motivation of this deal.

Wrinkles, twists

An irony of the network effect comes from the auction nature of keyword buys.  Advertisers bid for the right to get their message in front of customers.  When more advertisers are competing for the targeted eyeballs of consumers, the prices for advertising go up.  This means that prices will tend to be higher on the larger ad networks.  So bargain seekers can get more advertising for their dollar by seeking out smaller networks.  This appears to contradict the logic that bigger is better for ad networks.  But many advertisers are limited not so much by budget but by the ability to reach highly qualified customers.  If you are selling poodle tattooing services in the pacific northwest, odds are you will not hit max out your advertising budget on any of the ad networks simply because not that many people are searching for your services.

I could probably fill pages with speculation about the culture clash between Microsoft and Yahoo and other reasons why it will or won’t work.  But if you’re interested in that stuff, I’m sure you’ll have no problem finding it in the backwaters of the blogosphere.  I can’t help but drop a couple relevant ideas though.  First, from what I hear, the executive management at Microsoft is so dysfunctional right now, Yahoo will provide fertile new ground for their turf wars.  If the top bosses are adept, they will use the many iterations of re-orgs to sluff off ineffective execs to projects where their overall damage can be minimized.  Second, I think I hope Microsoft has evolved enough humility to understand that they’re better off simply shutting down Yahoo’s services than forcing everything to port over to NT servers.  Right, guys?

Disclaimer

I feel compelled to point out that the opinions expressed here are mine and mine alone.  In no way does this article reflect any official position of my employer.  This is my personal analysis of the economics behind the industry I work in.

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