How do search engines count the overlapping keywords in web site content? If, for example, I want to target "blue sky" keyword and I have in the content "pale blue sky" does that count as 2 keywords ("blue sky" and "pale blue sky") or just as one ("pale blue sky")?

From a search engine perspective, it will count as two, but it really depends on how the user will search for you;

pale sky
pale blue
pale blue sky
blue sky

So in essense you really have 4 terms in that. The more descriptive you are, the further your reach will be. Having the two words together will give you a boost. So searching for "blue sky" the "pale blue sky" will show up, but if you had "blue pale sky" then it gets a lower rank as there's a word separating them.

It'll still rank though.

seach engines grab words separately from you search inquiry and by the magic of their algorithm, crunch out pages that has those words (or anything close) in it.

So, in that sense you actually have multiple keywords possibilities.

How then should I count keyword density on my pages? For example, i target both "blue keyword" and "great blue keyword". If i include both of them 5 times that is 10 times "blue keyword". I suppose I should put "great blue keyword" just 5 times.

Basically, I'm afraid that search engine won't count that as two, or give them authority as for two, or will it?

You're getting into an area called keyword blurring. What you reference are keywords, keyword phrases and extended keyword phrases.

To take this one step forward. Focus on using specific extended keyword phrases on one page only. On internal links, use keywords or keyword phrases to link to pages using extended keyword phrases. Keywords like hosting will naturally be repeated throughout your site, but extended keywork phrases like "business class shared web hosting" should only be linked from keywords or keyword phrases to a landing page devoted to business class shared web hosting.

OK, let me summarize what you said and you correct me if I'm wrong:

1) Every page should target different extended keyword phrase.
2) Use keywords/keyword phrases for internal linking

I have a good practice of doing the 1st rule. But can you please give me the reason for the 2nd rule? I build internal links very carefully because they are very important, but I only use extended keyword phrase in anchor pointing to page that targets that extended keyword phrase.

Basically my question about the 2nd rule is why use keyword/keyword phrase when targeting page with extended keyword phrase?

Practice 1 is something that everyone should do.

The 2nd part for the internal linking shows search engines what is important. Basically you're using keywords to link to other related articles. This helps google and still gives you the keywords on the page. So when google then looks at the 2nd part (where you had linked to) and goes back to check to see how people are linking to it, it finds YOUR PAGE with relative terms and picks up on that.

Linking to a page with "click here" does nothing to help you harness the power of a search engine, but "click here for more information regarding keywords" would be better, and the more you can harness the phrase into something users would search for, the better your listings can get.

Look to Wikipedia for ideas on cross linking articles.

Thanks for that post, it is excellent! I'm still interested on what Steve-Hostirian meant. Why not use extended keyword phrase in link anchor to page that targets that phrase? Why are you using just the keyword and not the extended keyword phrase in anchor? Do you want to pick up broader traffic in that way?

The reasoning is NOT to confuse the search engines. Extended keyword phrases should be unique to their specific landing page. If I'm searching for "business class shared web hosting," I don't want my prospect landing on a page that isn't relevant and simply links to the page that is relevant.

OK, thank for the answer. That sounds reasonable. I was just confused. Although it does seem that just one link on some irrelevant page won't beat the actual relevant page in SERP, but I guess reality is different.

Well i think Pale is a keyword, Pale blue sky is a keyword phrase so as Pale blue Sky, and the rest listed are the keyword phrase combinations

Well, I think that it is just a matter of to which specific keyword you commit on a certain page. For example, if you opt to target page to "incredibly pale blue sky" you will have search engine picking all combinations. BUT, if you give search engine a hint by putting "incredibly pale blue sky" in the title, headings and bolded text, you'll be alright.