So how did they get here: By understanding something about human psychology, and then HACKING it for all its worth.

1) Addict people with SIMPLE, low learning-curve games, that 2) are social in the way you might have played certain board games in real life in the past, and that 3) have Irregular Reward Schedules (these are the most addicting forms of behavioral reinforcers, read up on your Behaviorism 101…).

THEN, 4) offer them little ways to essentially cheat in the games (making things go more smoothlyfor you), that 5) can be purchased for amounts that fall within the Impulse Purchase threshold, i.e. below the price level where your conscious mind kicks in fully and begins to wonder whether this is really a good idea, asf.

Read the following quote at least 3 times to yourself: “Zynga makes all its money selling virtual goods…Tiny amounts of money make the games progress faster.” (From Business Insider.) If you get it, you’ll know that tons of companies have been neglecting/violating the lessons therein to their considerable detriment.

I just argued yesterday that Sony is making a huge mistake by not going the $1/month route for complete/unlimited streaming music access with their new offering:

Another example that I saw just yesterday: Clever Twitter service “Buffer” ( @bufferapp ), which allows you to in essence do a bit.ly-like bookmarklet share to Twitter WITH automatic posting throttling/buffering built-in, so that your tweets are dripped out over time even though you can batch collect them all at once over, say, your morning blog reading hour:

All great, except that they are mispricing their premium levels very badly: 10 tweets in buffer, 3 tweets a day is Free. $5/month for 50 tweets in buffer, 10 tweets/day dripped, and $30/month (crazy…!?) for all unlimited is simply not going to work for them IMO. [See: http://www.bufferapp.com/pricing ]

$5/month is outside of impulse purchase range, while $1/month = Bingo! Sold! At $5, your mind is beginning to ask: Do I really need this? Is it worth it? Can I justify it directly via increased ROI? Where/how am I even going to measure this ROI?

All questions that you DON’T WANT your prospective customer asking at the entry point!! Which is exactly what Zynga has realized so brilliantly, and to such obvious success. The proof of the (psych) pudding is still in the eating… Zynga: “Would you like to improve your position in this game you are already playing for 10 cents?” – Unconscious Mind: “You bet I would.”

Which brings me to another of my pet points about successful online advertising/selling: Offer people only things which make sense in the context of what they were ALREADY doing. In this case, don’t try to offer them after shave, bracelets, or cars while they are playing Farmville, offer them something to do with Farmville!

Disclosure: I don’t play Farmville or CityVille, and have never tossed sheep or vampires at my Facebook friends. I do however study these phenomena very closely… :)

But what makes Google’s new "sponsored videos" feature on YouTube even more relevant is today’s news that YouTube searches now represent the second largest search engine in the world according to ComScore, ahead of both Yahoo and Microsoft’s MSN/Live! So there should be ample room for YouTube to generate profits for advertisers and in turn for itself (Silicon Alley Insider estimates that it could add $1B to Google’s bottom line).

However, as I began to lay out yesterday, there are a number of caveats that need to be kept in mind by the internet marketer looking to take advantage of this opportunity:

1) Marketing within Social Media (vs. search ads PPC) is generally tricky due to a deeply rooted differentiation by most people between social and business contexts: People don’t like them mixed, and can react very negatively if they are (read Dan Ariely’s excellent "Predictably Irrational", chapter 4 "The Cost of Social Norms").

2) So if you are going to market in any social context, you need to get the tone and the context just right, else you are not only wasting your ads, you are likely hurting your brand. The backlash may also be much stronger than in other situations, because you will be dealing with a perceived violation of social trust.

Whatever initial offer you make needs to still fit into the "friends" context somehow, or else be so targeted that the prospect truly sees your offer as a form of "friendly service", e.g. if you are offering something that would help with a social task they are about to undertake, like offering flowers at a special price if someone is surmised to be going on a date, etc. (judging from e.g. a Facebook "action" of theirs).

3) While YouTube is overtly the least directly social (compared to say Facebook, etc.) and instead more entertainment oriented, the social aspect of sending/receiving video clip links to/from your friends is still clearly there. So to stay in tune with the viewer/prospect, you still need to get the CONTEXT just right:

If the search keyword (or individual video for that matter) is an entertainment vehicle first-and-foremost, then offer them more (hopefully related) ENTERTAINMENT products, NOT shoes or cars or deodorant. This goes for pre- or post-roll ads as well by the way, which prospects tend to gladly view IF they have something to do with the actual video content requested.

With more educational keywords/videos, there may be more latitude to offer things, though they still need to be related and represent a LOGICAL follow-up, else your sponsored video will get largely ignored/filtered out by the prospect just like most other ads (even though, as I said yesterday, Google appears to be embedding the ads very discretely, so that they don’t scream "ad" vis-a-vis the other video content).

So the formula would be, create videos that are highly relevant to your keywords, while also being disruptive enough to get attention.

In a word, Google is starting a new "sponsored videos" feature on YouTube that will follow their well proven keyword/Pay-per-click (PPC) model, only now with videos instead of the familiar (and mostly ignored) Adsense text ads. This should be a great opportunity for those internet marketers already further along with their video efforts.

It should be pretty cheap to bid on the YouTube keywords at first, due to limited competition on them (the barrier to reasonably well-produced, well-converting video is still high, a lot higher at least than for text/image websites), and the click-through rates should be high because the videos blend right in as just more video content.

Note that the appearance of the still screen shot shown for the video before play will be crucial to attracting extra attention (like a well-done display ad). But in principle, nothing about this form of "ad" will make it so that YouTube viewers will mentally block them out – which usually happens even unconsciously after a short while, because the "ads" are, well, videos, the same thing that the user was looking for in the first place.

But if done right, it can be the equivalent of an advertorial, a marketers dream…

An important caveat applies here: You want to be sure to get the context right, i.e. deliver a video that will be perceived as relevant, or even value-added to the user’s keyword search. Else you will garner exponentially negative brand equity, as users will feel betrayed.

Again, I’d say Google just changed the game today as far as their ability to monetize YouTube is concerned (which was pretty poor so far), but it also should be a great avenue for internet marketers: Instead of wasting time trying to manipulate the YouTube view rankings, or having to "viralize" the videos some other way with a high failure rate (although if you can have that built in, the effect after the initial sponsored promo phase could be multiplied!), you just buy the "in".

Of course, you’ll still have to know what you are doing in terms of direct response marketing to get prospects to convert from the video, and make the numbers work reliably for you.

The three-way "negotiations" between Carl Icahn, the Yahoo board, and Microsoft turned up another non-starter offer for MSFT to cherry-pick Yahoo’s search assets, which in turn led to much finger-pointing, and general acrimony.

The result is that Icahn may now be out of the picture, and that Yahoo will survive through its August 1 shareholder meeting. Unless Microsoft comes back with a last minute complete buy-out offer at a guaranteed, cash-equivalent price that is ($29 per share would seem like the absolute minimum in this regard).

But it all seems increasingly unlikely, leaving Microsoft without a strategy, and Yahoo desperate to get past the distraction of the entire episode, and its operation back on track.

Jerry Yang is apparently begging his troops to keep working (for the second time in two months), and as I previously pointed out, for good reason. And even though we don’t hear similar exhortations form inside the Microsoft bunker, there is little doubt that Microsoft is not similarly affected:

During the entire first half of 2008, the only news out of Redmond other than the Micro-hoo botched deal attempts, has been the announcement of the "Live Search Cashback" (LSCB) attempt to sort of buy search query share using a rebate gimmick (that had failed to work before). That MSFT and some commentators touted this as a "game changer" proves the depth of their dilusion.

I have been working on a detailed post for why LSCB was such a bad idea in many (technical) ways, but the end-result is much easier to ascertain through some simple tests: I occasionally have been checking LSCB price quotes against Google search results for identical items, and the FREE(!) product listings at the top of Google Universal Search beat the LSCB prices with the "discount" (that MSFT is kind enough to hold in escrow for you for up to 2 months) MOST OF THE TIME!

I expect ComScores due out this week to tell the tale that Live Search Cashback has caused nary a blip on the search share radar screen. Even Microsoft seems to not be talking about it anymore…

During the same time frame, Google has had major announcements regarding their OpenSocial, GoogleGears, Google App Engine, and Google Android (Google’s mobile phone) software kits, all the while honing their core search and search ad serve in the background. Even Yahoo recently announced a relatively substantial opening up of their search toolkit to developers for third-party applications.

Back to Yahoo’s Serious Issues

In recent weeks, high level departures and reorg moves by the Yahoo board’s Sue Decker, have highlighted again how deep the rot of bloated hierarchies and excessive middle management has gone inside Yahoo. I had previously reported some signs of the same thing on this blog.

The question is if this can be turned around in any meaningful way. And by the way, there is a huge question as to whether MSFT/Steve Ballmer would be doing any better, they are not exactly masters of nimbleness and have ZERO credibility when it comes to making a profit on the Internet.

Yes, Yahoo still has reach and scale, but what is really needed is a clear vision and marching-order on what Yahoo is supposed to stand for going forward. Their lack of focus has been their achilles heel the entire time.

While Google has built "Google = Search" brand in a (mostly) disciplined way, which is one of the key reasons for why they have been able to monetize better on search (people come to their site with a relatively defined mindset), Yahoo = what?

Yahoo’s portal strategy has been an albatross around their neck almost from its beginning.

Add to this the slowness in response due to the excessive hierarchies, and that is all you need to know as to why they haven’t been able to compete with Google. It’s a simple focus and positioning issue.

(The argument repeated again in a comment on Silicon Alley Insider by supposedly a Yahoo employee that Google monetizes better vs. Panama due to larger query share is simply false: It is about the average user mindset/context gap. Remember that Yahoo once had a lot larger share of search. So that’s not it.)

The only thing that Yahoo can do now is to decide how they want to position themselves, ideally in a new category instead of as an also-ran, and then stick with it and execute. But that decision must come first.

I for one see a lot of potential in making Yahoo into one gigantic open social network from the inside out, and among other things leveraging their user base to create a supplementary user-generated/rated search a la Mahalo and Digg.

Plus open up all of the spickets to leverage open source development assistance. If they still want to be in search and search ads, outflank Google by opening up the kimono to advertisers and become the "transparent search ad platform" vs. Google who like to keep things close to their vest.

At this point, they need to create an undeniable, compelling reason to get the advertisers back and hence the monetization up. Also, if they can begin to create context-targeted "social ads" a la Facebook (only better) inside of a newly created "Yahoo as Social Network" (see above), they could leap-frog Google search because Google still knows very little of real substance about the individual user at this point.

It’s all about proof of concept right now, and the more radical the better, as only that can have a chance to generate mindshare and get people to start using the new services. Everything must be on the table. I hope Jerry and Co. are seeing this on the inside.

But this time even usually stalwart Micro-hoo cheerleader Michael Arrington of TechCrunch is saying that Microsoft may be going too far in its Machiavellian machinations to want to feast on Yahoo’s carcass.

Meanwhile David Kirkpatrick, senior editor of Fortune Magazine, argues that Microsoft will inevitably buy Yahoo, making the case that it has gotten personal for Redmond ever since Google wrested the crown of perceived "greatest and most powerful tech company" away from them.

But in arguing that Microsoft desperately needs Yahoo’s scale, Kirkpatrick falls into the same "scale will solve things" thought trap that is deluding Microsoft, and plenty of commentators throughout the blogosphere in both posts and comments as well.

Currently Google’s monetization advantage vs. Yahoo (confirmed, and likely similar vs. MSN/Live Search), that comes from their focused execution is somewhere around 50-100%. And it has NOTHING to do with "scale".

It has everything to do with the advertisers being able to afford higher average bids due to higher average conversions. Period.

Conversion is the only thing that ultimately matters to an advertiser. Scale is a straw-man. If YHOO or MSFT had equal or better conversion numbers for the same keywords, then advertisers would jump on that. The individual advertiser could care less about the total query share numbers, or total number of clicks, they only care about their ads converting when they are being shown and clicked on.

If you mail a direct response ad, do you care what total percentage of the region or nation that mailing list reaches? No way. You care about the conversion numbers, because if an ad doesn’t convert you can’t long afford to mail/run it. In search ads, if you fail to convert the clicks you get, as a small business you can be bankrupt before you know it. It’s that simple.

The total volume of searches or even clicks for a keyword on Google, Yahoo, or MSN/Live has little or nothing to do with it. It’s simply that at lower conversion rates on Yahoo or MSN/Live, advertisers have a harder time making the economics work for them.

Steve Ballmer should change his tune at the next Microsoft company meeting:

Conversion, conversion, conversion…

Few people in "big business" understand direct response models, but that is what search advertising ultimately is. It is NOT image advertising, because Google text ads, whether served with search results or on websites and blogs as "Adsense" ads, do not lend themselves to branding exercises like display (image) ads or TV commercials.

The old adage of marketers – "I know half of my advertising is wasted, the problem is, I dont know which half" – does not hold true for the direct response model that pay-per-click ads served with searches or with content are based on.

Any advertiser with a basic understanding of the Adwords campaign management backend can tell EXACTLY which half is not working, then tweak the keywords, ad copy, asf. and turn off non-performing ads/keywords in short order.

Myth #2: "Affluence Gap"

A similar oft-repeated myth is the following statement taken from an Alley Insider comment:

Google has [...] the most affluent search users. Therefore, ad buyers want their ad to be shown on Google, and the price is bid up.

It isn’t about the supposed greater affluence of the Google users at all, otherwise Yahoo could not outsource THE AD SERVES (NOT the searches) to Google and instantly get 60-80% higher returns. Note that we’re talking about the very same (Yahoo) search users as before.

It’s about Google’s superior monetization that is due to their fanatical refinements of ad serves and the search results themselves, AND the higher conversion rates that the advertisers are experiencing.

Now there is one other side to this that is in fact branding/positioning related: The context in which an ad is served. With Google, since Google = search, users are in a "searching for a solution" mindset much more so (on average) than on Yahoo (or MSN), where people may be for any number of reasons (social, email, IM, news, etc.).

This is the real draw-back of the portal strategy that Yahoo and MSN embraced, which by definition leads to brand dilution: You have no idea about the exact user mindset, and many if not most of the pages you serve create contexts that are counter to anyone clicking on ads.

How many ads have you personally ever clicked on that got served with your free online email? Your chat? Your Yahoo groups, etc.? Chances are, none. After a brief period of mental adjustments, you likely started to completely ignore those ads.

Even Google had to learn this lesson, when they found last year that the social networking inventories for Adsense ads (e.g. on MySpace) were monetizing far lower (because converting less) than expected: People just weren’t looking to buy when networking on-line. It’s two different things.

From the point of view of the advertisers, all that matters to them is per-click cost and conversion. That alone determines whether their PPC campaign is viable past a few days. If Yahoo could allow them to get workable numbers, they’d be more than happy to bid higher on Yahoo’s search inventories.

So it is this mindset context differential rather than any affluence disparity, or the vaunted "search share" scale myth, which gets even usually smart and tech savvy people like Alley Insider’s Henry Blodget to drink Microsoft’s Kool-Aid on why they need Yahoo’s search division.

As long as this myth persists, there will likely be no peace for Yahoo.

Today, Microsoft apparently walked away from a Yahoo deal more thoroughly than they previously had, which in itself makes little sense and proves how much Ballmer and Co. have kept themselves in suspended animation during this ongoing saga.

Now, as far as Yahoo was concerned, we knew that they wouldn’t get a lot done given the continued wheeling and dealing by billionaire investor Carl Icahn. Despite Jerry Yang’s pleading with the troops to keep their noses to the grindstone, there is simply no way that Yahoo has not been deeply affected:

I was at Sprint in a former life at the time when the proposed merger with WorldCom was going on, which ultimately, and it turns out mercifully, was blocked by the DOJ. And I can tell you from that experience that very little of substance beyond basic maintenance mode happened inside Sprint for well over 6 months.

All eyes, minds, and water-cooler conversations were cued on the proposed deal and its ramifications. And that was under relatively amicable circumstances mind you.

So, with the pronouncements by MSFT today, Yahoo’s stock taking a big hit, and Yahoo in turn announcing that a deal to outsource search ad serves to Google may be happening as soon as today, someone might be tempted to say: The nightmare is over.

Or Is It?

Despite all of the "titillation", the Icahn back-and-forths, the rumor, the innuendo, and the inflated/bruised egos, let’s take a step back and look at the fundamentals of this:

MSFT + Yahoo = Still Can’t Compete

As Henry Blodget of the Alley Insider has previously argued (and I agree with him on this), the Micro-hoo deal as originally proposed does preciously little to make the combined entity more competitive against Google. MSFT has amply proven as much recently by having to resort to touting their "Live Search Cashback" gimmick as a "game changer." NOT a good sign. (I was in the middle of putting the LSCB discussion into this post but will save it for later).

You see, entrepreneurship is fundamentally concerned with arbitrage, that is, putting resources towards their highest and best uses. And combining MSFT’s money and inferior technology together with Yahoo’s inferior technology and user eyeballs does NOT a winning combination make. Period.

If you combine money with eye-balls, what have you got? A waste of $ and a combinatory nightmare.

I previously said that

joining the two juggernauts into one operation is the equivalent of having two huge battleships collide at about a 45 degree angle and hoping that somehow during the collision they will weld themselves into one aircraft carrier. Ain’t… gonna… happen.

And MSFT has proven with each of its Internet moves in 12 long years that it is very adept at actually driving AWAY eyeballs despite all of its supposed and real advantages (its installed browser base, money, influence, etc.).

Part of this is their extreme misunderstanding of branding and the resulting branding mess that I have been reporting on here several times already, and their failure to understand the internet at a fundamental level.

So if Yahoo moves to outsource the ad serves for its search to Google, in entrepreneurial terms, they are doing the right thing. Take the money now and gear up to fight another day on NEW battle-fields where it can actually WIN.

Remember that Google’s monetization advantage is somewhere between 50-100%. Now that is a combination that actually makes economic sense: Leading eyeballs to instantly higher monetization, something that Micro-hoo might well have never achieved.

While it is true that Yahoo shouldn’t completely get out of the search game, instead of playing also-ran, they need to innovate on a massive scale. Keep the R&D going in the background, and use the newfound money to do something worthwhile.

Which is by the way what MSFT should be doing rather than continue to try to throw its weight around. It hasn’t worked on the internet in 12 years. In this context it is ironic that MSFT might now be trying to push for regulatory protection against a Goo-hoo outsourcing deal. THE monopolist of the late 20th/early 21st century crying foul… that would be so rich…

Even more ironically, if MSFT hadn’t been able to stop the DOJ proceedings against it through the arrival of the Bush admininistration, and had been broken up into say three smaller, more nimble, more hungry units, both those resulting companies and all the rest of us might well be better off today:

Vista might have been less of a failure, the Office company might have actually innovated in the "productivity" space, and the Internet division would have been free to "get" the internet unencumbered by other interests.

Back to the Goo-hoo outsourcing deal

Critics of this scheme are right that this can only be seen as a short-term fix to boost Yahoo revenues. If it’s not accompanied by very serious efforts to innovate and therefore outflank Google or create new markets that Yahoo can take a leadership position in, then it does hurt them in the long term. Their capabilities would definitely erode.

This was described in some detail by Mahaney in the TechCrunch interview, where he recounted the developments at AOL. (The full text of the interview is really a must-read for anyone interested in this entire situation.) But of course it would be up to Yahoo with how they spend that money.

If they invest it in serious innovation instead of mee-too projects, they might have a shot. As it stands now, there is very little in terms of core competencies that they have really kept even or led on.

Whatever they have going for them up to now is largely a hold-over from its successes during the Web 1.0 phase. That is predominantly the user eye-balls, people who became accustomed to using Yahoo services circa 1996-2000. They have since bungled almost everything else they touched, from search ads (where they should have led with Overture), to the rise of social networking and web video (where they largely missed the boat).

So again the critics are partially right in that Yahoo’s search share will likely keep declining over time (not rapidly though), simply because they will fall further behind in search development as well. UNLESS they make a very serious effort to come up with a next generation of search that somehow bypasses what Google is currently doing. Otherwise, they would of course be more and more dependent.

Of course, it’s Google that is hard at work figuring out the next steps in search… while MSFT and Yahoo just wasted another 4+ months on this diversion. And who knows, maybe Ballmer or Icahn will do it all over again in a few months.