To use images in mail merge, the image must be a publicly hosted link. You will have to host your image on another location and provide that as the "source".
You can host the images on your website or on a free hosting site - like imgur.com. Once your image has been uploaded, copy the URL of that image. You’ll want to copy the exact URL of the image, not the page that contains the image. From there, open a new mail merge and use the “Insert Photo” button from the menu of formatting tools. In the ‘Source’ field insert the URL that you just copied for your image.