Would you pay $15.99 for a CD of your favorite recording artist if you could get it for free on the Web? This question has shaken the music industry to its foundations. A tremendous number of Internet users have taken advantage of online file-sharing services where they can download digitized music files from other users free of charge.

          The first such service to be widely used was Napster. Its Web site provided software and services that enabled users to locate any of the 1 billion digitized MP3 music files on the computers of other online Napster members and copy them onto their own computers for free. Napster�s own computers did not store any music files, but instead acted as a matchmaker. To obtain a specific music file, you would sign on to the Napster Web site and type in the name of the desired song. Napster�s central title index would display the connected computers with that specific song. Napster then established a direct connection between the requesting computer and the one storing the desired music file. Your Napster software then would download that file onto your computer. You could play the song on your computer and copy it onto CDs. If you stored it on your computer, others could copy it from you. Napster quickly became so popular that when it was shut down in 2001, it had more than 80 million users worldwide.

          Napster users could legally copy and trade uncopyrighted material, but reproducing copyrighted files without permission is illegal because the recipient does not compensate the owner for the use of the intellectual property. In December 1999, the Recording Industry Association of America (RIAA), representing the five major music recording companies (Universal Music, Sony Music, Warner Music, BMG, and EMI), which together were responsible for 80 percent of recorded music, sued Napster for violating copyright laws. U.S. courts ordered Napster to stop allowing users to share copyrighted music files, and the site closed down in July 2002 when it declared bankruptcy. It has since been transformed into a legal fee-based online digital music service.

          Napster was held liable for the illegal copying of copyrighted songs because it maintained a central index of members� music on its own central computer. Its closure did not stop widespread illegal music file sharing. Alternative �peer-to-peer� approaches to free downloading were developed that did not require a centralized computer to manage the file swapping. Services using this approach include Kazaa (KaZaA), Morpheus, and Grokster. Many of the estimated 37 million Americans who have downloaded music have done so using Kazaa. According to research firm BigChampagne LLC, users download more than 1 billion songs per week from Kazaa, Morpheus, and other file-sharing programs.

          Kazaa�s corporate headquarters are located in Vanatu, a tiny independent island near Australia. Kazaa�s software is stored on individual computers, enabling anyone to locate servers where individuals have stored music files available to be copied. Once the software locates the desired song, it establishes a direct peer-to-peer link between the two computers and downloads the desired song file, with no one paying any fees. Distributors of the software claim that their software has valuable legal uses, and they are not responsible if millions of people use it illegally.

          To profit from its software, Kazaa allows pop-up advertisements and unsolicited e-mail from vendors who pay for the service. Because the free trading of digitized materials does not go through a centralized computer, no one knows what or how many songs are being downloaded or by whom. But Kazaa reported that, by June 2003, its Media Desktop software for computer-to-computer file sharing had been downloaded 270 million times.

          The courts have been unable to shut down sites that only make the peer-to-peer software available. On October 2, 2001, through RIAA, the major record label firms filed suit against Kazaa, Morpheus, and other peer-to-peer services, alleging copyright infringement against all firms who use Media Desktop and similar software to swap copyrighted materials. However, because the exchange of music files is strictly between two individuals, Kazaa claims it is breaking no laws and so cannot be shut down. Instead, individual users of Kazaa�s software are breaking laws and can be punished.

          A big blow against the recording companies came on April 25, 2003, when a suit brought by the major record labels, movie studios, and music publishers against Grokster Ltd. (Grokster software) and StreamCast Networks Inc. (Morpheus software) was decided in favor of the file-sharing services. The U.S. District Court in Los Angeles ruled that the two companies could not be held responsible for illegal music swapping using their software because they cannot monitor or control how users of their software exchange files, and so they were not breaking any laws by making their software available. A subsequent ruling on August 19, 2004, by the U.S. Court of Appeals, Ninth District in San Francisco upheld this earlier ruling.

         RIAA started to prosecute first students and then other individuals use the Internet for illegal music downloading. The effort began in the autumn of 2002 with 2,300 �cease and desist� letters to colleges, warning them to stop their students from downloading music. RIAA then filed a suit against four individual students in an attempt to stop students from downloading free popular songs illegally and then making them available for other students to copy. In an out-of-court settlement on April 30, 2003, the students agreed to cease their music downloading activities and pay RIAA more than $10,000 each. Immediately after the agreement, a number of similar file-sharing networks on other campuses were pulled down.

In the spring of 2003 RIAA started sending Kazaa and Grokster users millions of instant messages which said, �When you break the law, you risk legal penalties. There is a simple way to avoid that risk: DON�T STEAL MUSIC.� Then on September 8, 2003, RIAA filed lawsuits against 261 American computer users whom it believed were using Internet file-sharing services to distribute and download large amounts of copyrighted music illegally. RIAA launched additional suits against users of online file-sharing networks, targeting 532 people in January 2004 and 744 people in August 2004. Legal experts expect most of these lawsuits to be settled in favor of RIAA, but these suits are unlikely to halt illegal music file sharing.

Although RIAA�s legal campaign has frightened some illegal music downloaders, many individuals continue to believe that there is nothing wrong with downloading and distributing copyrighted music. This widespread attitude cannot be easily changed. The music industry believes that widespread music file sharing on the Internet has caused music CD sales to plummet and that Internet downloading is costing them billions of dollars in lost sales each year.

In 2000, CD sales were about $35.5 billion; in 2001, sales fell to $33.7 billion, a decrease of 5 percent. According to Nielsen SoundScan, CD music sales fell another 8.8 percent in 2002. In 2003, U.S. recorded music sales only fell 0.8 percent from 2002, but worldwide, sales fell around 10 percent.

Critics of the recording industry claimed that sales slipped only a little in the falling economy. A Jupiter Research report of May 2002 and a report by Professor Felix Oberholzer- Gee of Harvard Business School and Koleman Strumpf of University of North Carolina found that those who use such free Internet file-sharing networks as Kazaa to download songs are more likely to increase their spending on music than other music CD purchasers. These reports concluded that free downloading increases music CD sales by getting people enthusiastic about new and catalog music.

Critics pointed out that the number of industry releases has fallen sharply, from a record 38,900 titles in 1999 to 31,734 in 2001, a 20.3 percent drop. Nielsen also reported that although the 2002 releases rose to 33,443, that was still a 14 percent drop. �The music industry�s [approach] is to throw things against the wall and see what sticks,� said Nathan Brackett, Rolling Stone�s senior editor. �If they�re throwing 20 percent less stuff out there, there�s less chance something will stick.� Also, the average CD price rose 7.2 percent between 1999 and 2001 from $13.04 to $14.19, whereas consumer prices rose barely at all.

Critics believe that new forms of competition for entertainment dollars have also contributed to the drop in CD sales. For example, 35 percent of U.S. homes had DVD players in 2002 versus none in 1999. DVDs, video games, and the Internet are becoming strong competitors for entertainment dollars.

Observers emphasize that those who continue to download songs for free actually do face costs. First, users must spend time downloading the music. Then, to play it anywhere but on their computers, they must �burn� it onto compact discs. Moreover, specific songs can be hard to locate. And users have to endure technological problems, including pop-up advertising to pay for the �free� services. Also, prior to downloading, users cannot tell if the song contains a computer virus, is only a virus, or is otherwise a phony or incomplete song. The quality may even be poor, including scratching and popping sounds. Students may have time to experiment, but most people with full-time jobs do not.

          The recording industry now realizes that it must change the way it does business if it is to survive. Some industry analysts believe it must find ways to cut costs. Michael Nathanson, the music analyst for Sanford C. Bernstein, said the biggest costs (about 36 percent) were talent and marketing.

          Some analysts recommend that recording companies consider signing fewer artists. According to Michael Wolff of McKinsey & Company, �The revenues today can�t support such a broad number of releases.� Others believe the only way to cut these costs is through consolidation, perhaps cutting the major recording companies from five to three. However, because overhead amounts to only one-third of recorded music costs, the savings would be limited and inadequate. Some claim the underlying problem is that entertainment executives compete with each other for a limited pool of talent. Nathanson suggests the companies need to rely on other sources of revenue. For example, he believes they should get a portion of artists� earnings for concerts, sponsorships, and merchandise sales, all of which are currently kept by the artists themselves.

          For years, the recording companies balked at licensing their songs for legal sale online. Most of them burdened the music with unwieldy technical safeguards that prevented consumers from recording songs onto CDs or transferring them to portable music players. These services often required monthly subscription fees, offering too few songs and at too high a price per song. They were not very successful.

          In 2002, the major labels did a turnaround and started to embrace online music sales. They began experimenting with alternative pricing structures for music delivered legally over the Internet. Some executives believed that the industry should not sell songs individually (as over the Net) because people will purchase a whole CD to get one or two songs. However, with the proper price, individual songs could be effectively sold. Tests showed that above $1 per song, sales fell off rather quickly. John Rose, executive vice president of EMI, concluded, �If all consumers who pirate tracks today bought them for a buck, that would be a $5 billion a month business.�

          On April 29, 2003, Apple Computer announced a new Web site for downloading music named the iTunes Music Store. It was an immediate success, selling 1.4 million songs in its first week, and 100 million by August 2004. It stunned the industry. The site charges 99 cents per song and at first offered more than 200,000 songs. Apple has a licensing agreement with all five of the big recording companies and now has available all the songs in their catalogs.

          Users do not subscribe to this site, making it less expensive than the other sites. The person purchasing the songs can burn as many as 10 compact discs with the same list of songs so the whole family can use them. The site is easy to use. Songs can be located by genre, artist, or album, and they can be downloaded at the click of a single button. Album covers are downloaded with each song or album. Moreover, users can play a 30-second preview of each song for free. Most complete albums cost between $8 and $11, with the majority priced at $10. The songs belong to the purchaser who is able to copy them to as many as three computers (a restriction demanded by the big labels).

          iTunes has inspired a new wave of similar online music services, including Napster 2.0 (a legal version owned by Roxio Inc.), Sony Connect, RealNetworks, and BuyMusic.com. Microsoft and Yahoo! have entered this market and Viacom�s MTV and Virgin Group have similar plans. As in many other industries, this intense competition is commoditizing the digital music market. Outside of sales or limited promotions there is very little variation among the major music sites in price or tune selection.

          Online distribution of individual songs is still an unproven business model, and profits are very thin usually about 10 percent at best. Some believe that these sites are useful more as loss leaders to help companies sell other related products, such as portable music players or subscription services.

          Will reduced CD prices and Apple’s model be the solution for which the music industry as been searching? Or will the illegal downloading of copyrighted music continue to grow? The motion picture industry is anxiously watching because, as high-speed Internet connections become more popular, it may face the same fate as the recording industry. Will the living room become a war zone for digital entertainment or a thriving marketplace shared by the creators of content and the makers of the machines that deliver it?

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