In class last week we focused on keyword-search based advertisement auctions used by search engines such as Google, Yahoo!, and Microsoft. While the majority of the revenue of these companies is received through this type of advertisement, all of the big players in the industry are looking for ways to monetize e-mail and social networks in a similar fashion, but the circumstances are different, making it far more difficult.

A recent article in this week’s Economist, http://www.economist.com/business/displaystory.cfm?story_id=10880936, “Online Social Networks: Everywhere and Nowhere,” addresses the issues involved in monetizing social networking. The big players in the search engine industry, such as Google, Yahoo!, and Microsoft, are constantly seeking smaller start-ups to acquire in order to increase their returns on online advertising. The rational behind these acquisitions is that by owning more web pages the company will have more advertising space to sell. However, advertising has proven to be more effective in some forums then others.

Keyword based searches have rolled in the bulk of online advertising revenues, which makes sense as it is the most efficient means to target internet users. In keyword-based searches, most of the big players use the “generalized second price auction,” or GSP, to determine the order of the ads that appear when an Internet user inputs a certain keyword.

But a new trend of social networking has emerged and online advertising firms are scrambling to take advantage of the large number of page views. Currently, on sites that are not search engines, the industry players, such as Google, automatically determine the subject of the pages and display ads for which the advertiser has specified an interest in that subject. The ads show in boxes resembling banner ads, with the designation “Ads By Gooooooooooogle.” This is the mechanism used on the social networking sites among others. (For more on Google’s advertising mechanisms, visit http://www.asiaing.com/the-maximum-effect-making-the-most-out-of-your-google-adwords-account.html).

Based on recent transactions, it is clear that the Internet companies believe there are large revenues to be realized from advertising on the social networking sites. In 2006 Google engaged in a transaction with the number one online social network, MySpace, in which Google gained control of the placement of search-related ads on MySpace. Google also serves as the main MySpace search engine. Microsoft recently invested $240 million in Facebook, a transaction that values the company at $15 billion. The arrangement gives Microsoft control over the placement of banner ads on Facebook outside the U.S., where about 60% of Facebook’s 49 million active users reside (see article in Businessweek, http://www.businessweek.com/technology/content/oct2007/tc20071024_654439.htm?chan=search). This month AOL bought Bebo, a small but up-and-coming online social network, for $850 million.

The world of social networking has grown so large that it has led the big Internet companies to bid up valuations of social networking sites. However, unlike the keyword-based searches, online advertising in this area has not produced a working revenue model. Sergey Brin, Google’s co-founder, recently admitted that Google’s “social networking inventory as a whole” was proving problematic and that the “monetization work we were doing there didn’t pan out as well as we had hoped.”

Similarly, Microsoft has failed to realize gains on its investment in Facebook. Its new approach to social marketing, called Beacon, was an attempt to redefine the advertising industry, but it has failed miserably. The idea was to inform users of their friends’ online activities, such as when a friend purchased an item from an online retailer. When the purchase was made, a small announcement ran inside the user’s “news feed.” Facebook thought this would be a new form of word-of-mouth marketing. However, users were upset by the violation of their privacy.

These giants have pursued these deals with the intention of utilizing online advertising, yet none of these deals proven fruitful. This begs some questions:

• Have the Internet companies simply over-valued these social networking sites?

• If their valuations are correct, have they not yet realized the means through which they are able monetize the networks? Although Beacon failed, might there be other ways of redefining online advertising without violating users’ privacy that have yet to be discovered?

• Or have the social networking sites not yet reached their growth potential, at which point revenues from online advertisements will be realized?

Clearly this method of advertising on social networks needs to be revised if revenues are to be realized. While it may not be possible for social networking to produce revenues equal to those of keyword-based searches, it still has a tremendous amount of utility. According to the article in the Economist, “Social networking has made explicit the connections between people, so that a thriving ecosystem of small programs can exploit this ‘social graph’ to enable friends to interact via games, greetings, video clips and so on.”

Websites and applications in which users play each other in Scrabulous, post their pictures, follow their friends’ travels, or play fantasy football have found a home on these social networks. The vast number of these sites and applications linked to these socials networks has made them huge hubs. Like the search engines, these social networks are becoming very powerful hubs with substantial authority. Though they have yet to monetize these social networks, their enormous valuations of these sites indicate that the Internet giants see tremendous value and potential in these social networks. It is conceivable that the revenues that will be gained through them will be indirect. As they become large hubs, it will be the vast number of links through which the sites will be monetized using pay per click advertising. It will be interesting to see how these sites grow and if the Internet giants are able to find new forms of online advertising that will allow them to reach their valuations’ expectations.