As young people download singles off the Internet and CD sales collapse, record companies are scrambling for new ways to make money. But are the companies—and the CDs they sell—already obsolete?

What has happened to the big record companies?
They’ve become casualties of the digital age. As recently as 1999, the recorded-music business was booming, with revenues totaling $14.6 billion in the U.S. alone. But when all music became available in digital form, it became easy to copy it or steal it and share it on the Internet. By 2006, U.S. revenues had plummeted to $11.5 billion, and the decline shows every indication of accelerating. Through the first half of this year, CD sales are running a full 20 percent below last year. One stark sign of the collapse is the new definition of a “hit.” In the old days—that is, seven years ago—an album would have to sell about 500,000 copies to reach No. 1. But Johnny Cash’s posthumous release last June reached the top of the Billboard charts after selling only 88,000 copies. In today’s highly fragmented market, hit records also have far less staying power than when albums such as Michael Jackson’s Thriller held the top spot for months at a time. “Almost every core operating principle in the recorded-music business has been shaken or challenged,” said Edgar Bronfman, chairman of Warner Music Group.

Is music losing its popular appeal?
Not in the slightest. But the digital revolution has turned the business upside down. Thanks to music-downloading sites on the Web, young people are spending more time than ever listening to music on their computers and iPods. The problem is that many of them either are not paying for the tunes or are paying a lot less than they would be if they were still buying full albums on CD. One study found that consumers downloaded 50 billion songs in 2006, most of them illegally—costing the industry $12.5 billion in lost revenue. But it’s not just paying customers who are deserting the record companies. A growing number of musicians, including some big stars, have concluded that they no longer require the record companies’ services.

What are they doing instead?
They’re cutting out the middleman—the record companies—and taking their work directly to customers. It started a few years ago, when such artists as feminist folkie Ani DiFranco began handling their own recording and distribution. Now, a handful of superstars have also decided they can live without a major label. Madonna just left Warner Music, her label for 25 years, to sign a $120 million deal with concert promoter Live Nation, which will oversee everything from record distribution and live performances to merchandise sales. For their most recent albums, Paul McCartney and Joni Mitchell turned over their distribution to a distinctly nontraditional player in the music biz: Starbuck’s. “It’s a new world now,” McCartney explained. “People are thinking of new ways to reach the people.”

How is the industry responding?
Not very effectively so far. The industry seems to have devoted most of its energy to largely futile efforts to prevent illegal downloading. It can claim some legal victories, most recently in October, when an industry association successfully sued Jammie Thomas, a 30-year-old single mother in Minnesota, for downloading 24 songs. She was ordered to pay damages of $220,000—or $9,250 per song. But while it’s understandable that an industry would want to crack down on people stealing its product, the notion of big companies hunting and suing single moms and students has been a public-relations disaster. Besides, as one music executive told the Los Angeles Times, piracy is impossible to stop. “You can’t stomp it out. People are going to get it one way or another.”

What can record companies do?
The record industry has to find new ways of making money that do not depend on selling CDs for $16 apiece. Most companies now sell at least some of their catalog through iTunes, while some labels are experimenting with offering free downloads through their Web sites, hoping to entice consumers to buy some of an artist’s or band’s other songs. At the same time, the companies are devoting more resources to parts of the business that just a few years ago were mere afterthoughts or that didn’t even exist. Indeed, some record-industry visionaries say the future won’t have much to do with making physical “records” at all.

So what would music labels sell?
Music—but through a more “holistic” approach, tapping all kinds of revenue sources. The labels are already trying to re-create themselves as full-service firms that can help recording artists produce revenue in the form of CDs and downloads, concert tickets, merchandising, and licensing fees from movies and television, advertising, and mobile-phone ringtones. Ringtones, in fact, are now the fastest-growing source of music-industry revenue. “I find myself, when I’m signing a record deal now, asking, ‘Can this sell as a ringtone?’” said Steve Rifkind, president of SRC, a label affiliated with Universal. It remains to be seen whether such alternative strategies will save the day. “Everybody’s still hoping for the best,” said Joe Nardone, owner of Gallery of Sound, a chain of Pennsylvania record stores. “But the best ain’t what it used to be.”