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December 18, 2012
The Dismal Science
Creative Destruction
by Adam Smith

Recently in the news there has been a lot of talk about the demise of Hostess. I love Hostess products. When I was in high school I used to buy Ho Ho’s, Twinkies, or Suzy Q’s daily for lunch. Normally, I would consume a combination of 2 of the 3 (as well as the lunch prepared by my mom). And that was in addition to the stash I had in my bedroom for nighttime snacks. I even had specific techniques for ingesting these lovely pastries. As my taste buds matured, I began to prefer (slightly) the Suzy Q’s over the other two.

Naturally, people that know my preferred eating habits asked me my thoughts about Hostess closing their doors. I think they were expecting weeping and wailing and gnashing of teeth. They were a bit surprised about my indifference. They asked how I could shrug my shoulders when I would never eat a Twinkie again.

Based on the fact that Hostess products have landed on Ebay with a premium price, there are many other people that think these products are going away forever. I suppose that should be expected because that is what you hear on the news.

The reporting on Hostess only points out the glaring reality that people in the news media have absolutely no idea how business or the economy works.

We live in a free market economy. A free market economy remains vibrant and healthy through a process that some call creative destruction. There are businesses entering and leaving the economy all the time and Hostess is a great example of how this creative destruction process works.

Hostess was started about 90 years ago and created some great brands (see above eating preferences) that are very popular in the United States. The Company’s history spans that period in the United States when unions were very strong so it is not surprising that the Hostess manufacturing process was unionized. Over time the union was able to extract favorable labor agreements that the company could pay for (through higher prices) because of the strength of their brands.

Then other entrepreneurs saw opportunities in the baking business. Little Debbie sold pastries similar to Hostess at a much lower price but also with lower quality (at least to my palate). Then other bakeries entered the market at prices just lower than Hostess but with equal or sometimes even better taste (try the Mrs. Freshley’s cup cakes – delicious).

These bakeries could offer similar products at a lower price because they had a different business model. Their bakeries were not unionized so they had a lower cost of labor. This lower cost structure doomed the old business model of Hostess.

As consumers, we vote for the winners and the loser in the economy with our dollars. And in the case of Hostess, we were no longer willing to pay such a large premium for the brand when other alternatives were available.

This is creative destruction at work. A new business model is better than the old one so the new company thrives while the old one goes into bankruptcy. But in general to consumers, we get the same or better product for less money with the new company than with the old. With the extra money we saved, we can purchase other goods in the market creating increased demand and employment in other industries.

Another part of business that the media gets wrong is bankruptcy. Companies enter bankruptcy when they can no longer meet their obligations. Most of the time businesses go into reorganization bankruptcy courts. This allows them to shed some obligations, reorganize, and hopefully change their business model so they can compete again in the market.

This is what was so distressing about the auto bailout by the government. They gave the companies a lot of money so they could do a little reorganizing and meet their obligations but the rigors of going through bankruptcy court was not forced on the companies. Their basic business models did not change. Anyone think that a failed business model is going to suddenly succeed in the future? (Those Volts are everywhere aren’t they?)

Hostess did not go into reorganization, they when into liquidation. This means that all their assets will be sold, their creditors paid and then whatever is remaining will go to the owners. The biggest assets Hostess has are those brands. They are very very valuable.

Why am I indifferent about Hostess being liquidated? Those brands will be sold to someone who will continue making Hostess pastries but at lower cost and possibly lower price. That’s right, you may be able to eat the flower, sugar, and fat laden products for less than you have in the past. I am thrilled.

As a consumer, you have to love creative destruction.

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