The Digital Reckoning

By Karl Taro Greenfeld

The legal system may be the last refuge of doomed business models. When Big Steel and the auto industry were under pressure during the '70s from low-cost imports, their first instinct was not to change their outmoded manufacturing plants but to beseech the courts to bar the outlanders. The record industry has taken a similar tack, charging the purveyors of digital music with violating copyright law and Fair Use agreements. But even favorable rulings like the one the Record Industry Association of America won in district court against popular music website MP3.com provide only temporary respite. Sooner or later, the Darwinian economics of new technologies force businesses to adapt or die.

Two weeks ago, Lars Ulrich, drummer and founder of the band Metallica, unloaded boxes containing the names of 335,000 alleged music pirates in front of the San Mateo, Calif., headquarters of Napster, the software company responsible for the file-sharing program that has made the long-prophesied digital-music revolution a reality. "We're doing this because nobody else has the balls to," says Ulrich of a move that would seem to pit the band against some of its constituency.

But his stunt only obscured the real issue: the $40 billion music industry's business is evolving, painfully, from selling products to simply providing a service.

Selling compact discs was viable as long as the companies controlled the quantity and destiny of that music. Metallica CDs have been available only from stores, catalogs and online sites, and sold at a price that covers production, marketing, distribution, royalties to the artist and, not least, the markup for record company and retailer. That's why CDs that each cost 50? to make retail for $15. As long as the only way to get that music was through those channels, then Metallica and its label, Electra (owned by Time Warner, TIME's publisher), had a great gig. Last week a Federal Trade Commission settlement with major record companies put a crimp in that business. It said consumers may have overpaid $480 million in the past three years and that the companies would change their pricing policies.

The real threat to that business model, however, is client-to-client-based programs like Napster, Gnutella and Freenet that make searching and swapping MP3 music files quick and painless. Suddenly Metallica and Elektra no longer control the quantity and destiny of their songs. It costs zip to download Metallica's And Justice for All via Napster. If you're selling CDs, it's hard to build a business around that price point.

As a gatekeeper to its community, however, Napster may yet stumble onto a viable business. Its traffic has been growing at 1,000% a month, and venture capital is begging for a piece of the action. But what exactly is Napster's business? It doesn't produce music, nor does it store or distribute it. What it does provide is a service, acting as a kind of switchboard that connects users with the music they want. (Napster claims to skirt the copyright issue by moving files directly from client to client, never housing illegal files on its servers.) It could try to license this technology; it could figure out a way to sell music like a jukebox, and sell the "eyeballs" in the form of advertising. "The music business will become about growing the size of the crowd," says Jim Griffin, a digital-music consultant. "It becomes more like radio or television." The industry could thus shift from selling CDs to collecting subscription fees for its service, like cable TV. The record labels, or whoever succeeds them, also become gatekeepers rather than distributors of products.

As faster, wireless Internet connections become commonplace, artists will be compensated the same way they are when their songs are played on the radio, by the payment of a negotiated royalty per play or download. (The difference between playing and downloading becomes irrelevant in an always-on, high-bandwidth environment.) Either way, the business of selling CDs will be harder to sustain when free music is widely available.

The industry plans to fight rearguard actions until it has squeezed the last few billion out of its current business model. Metallica--whose members are unabashedly capitalist--was even willing to risk alienating fans to defend its copyright. "Technology is certainly leading the pack over the music industry as a whole," says Ulrich. "Does that mean music should be free? If you're a f______ plumber, does that mean you should come over and unplug my toilet for free?"

The labels may succeed in squelching Napster (which has already lost a major court battle) and Gnutella, an even more insidious file-sharing client. But right now, in some suburban bedroom or urban dorm room, a kid is probably hunched over her keyboard, working on a newer, faster, slicker piece of file-sharing software. And there's probably another kid in Bangalore or Brussels working on a better compression format. Ultimately, it will be technology and economics, not lawyers or megabands, that will call the tune in the music business.