It's important to consider that the Hohenzollerns and Habsburgs had been playing tug-of-war in Germany for centuries. It's hard to pinpoint the exact time this rivalry started, but by the time of Frederick the Great's decision to declare himself King of Prussia (rather than just King in Prussia, thereby violating the old Holy Roman Empire's "the only kingdom is Bohemia" rule; prior to him, the Hohenzollerns had been pretending they were only kings outside of the Empire), the rivalry was in full swing.

The rise of the Hohenzollerns meant that Austria was progressively losing more and more control over the northern German states. By 1866, Germany was more or less divided between the two great houses along religious lines: Hohenzollerns dominated Protestant Germany, Austria dominated Catholic Germany. But the arrangement was always somewhat informal. The North German Confederation, created as a result of the war, formalized the de facto vassalage of those myriad small states to Prussia and, in turn, meant that Prussia exercised far more control over the region than Austria ever did. The balance of power had irrevocably shifted.

But the war didn't just formalize Prussian hegemony -- it also gave the southern German states, states like Bavaria, incentives to maintain good relations with Prussia. This resulted in a number of defensive pacts. And, when the Franco-Prussian War broke out, Bavaria went to war on Prussia's behalf.

The Franco-Prussian War effectively destroyed Austria's hopes of ever contesting Hohenzollern dominance. Between effectively integrating foreign forces (like Bavaria's, which would play an important role at Sedan) and achieving such a remarkable upset victory over France, there was no way to dispute Prussian hegemony in Germany proper anymore. And when Germany was formed with Prussia as the nucleus, Austria was effectively removed from ever having a chance of being a major influence in the region again.

So why did Austria ultimately sign an alliance with Germany (not Prussia) in 1879? Simple, really: they had common enemies. Austria and Germany both (rightly) feared Russian military might. But Russia could never beat them both at the same time. Given that, a defensive alliance served Germany's interests by ensuring a steadfast ally on their southern front if Russia invaded. For Austria's part, it was expected that the alliance with Germany would prevent Russia from going to war over the Balkans (this obviously didn't pan out, but Austria was pretty much set on war in 1914). Austria was also not in a position to continue their rivalry with the Hohenzollerns considering they faced a very real threat from Russia, a latent threat from Serbia (remember, Serbia had an unusually large and effective army for its size), and there was no doubt that Italy would be opportunist if Austria was busy fighting another great power. An alliance with Germany was logical. Especially since Austria didn't really lose anything.