I think that small newspapers will survive because it's still the best way for people in a town to get a sense of what's going on in that town.
According to Daniel Akst, a freelancer who contributes to the Wall St. Journal, New York Times, Fortune Small Business (FSB) and other outlets, the Hudson-Catskill Newspaper Group is surviving on a formula of local "coverage and cost control."
I think we can agree on cost control, but Akst's point is that a lot of local papers don't actually offer local news: "Small-town papers often pay lip service to local news while filling their pages with generic wire stories," citing Prof. Philip Meyer's book, "The Vanishing Newspaper: Saving Journalism in the Information Age," which claims "that big-market papers typically have a lot more local coverage than small-market papers. One study found that over a four-day period the Detroit Free Press had roughly twice the proportion of local news as the Macon Telegraph."
I've seen that generic wire service copy in lots of small town papers. That's how services like NAPS and NewsUSA, which distribute matte releases, can offer pickup in hundreds of papers. (Though not my local paper.) I understand the rationale of matte releases, and on occasion, have recommended clients consider them.
But I do think it's a problem when too high a percentage of the local paper is filled with non-local news. That's when the paper is not doing it's job.
Check out Akst's article, "Write Local: How Small Newspapers Are Surviving."