We present an in-depth analysis of the music industry and use our findings to judge the practical assumptions and design of an original theoretical model. The model is in three stages, where, in a Hotelling-type framework, the last agents to act are consumers who choose between copying, purchasing, or staying out of the market for music. Prior to the last stage, the record label chooses its profit maximizing price and, in the first stage, we incorporate the artist-label bargaining agreement into a theoretical framework using the Nash cooperative bargaining solution. The current structure of the music industry is a combination of the oligopoly and monopolistic competition models, consisting of five major labels and many independents. Despite major labels' advantage in large-scale distribution, we argue that digital downloading has the potential to radically alter the current industry structure, and that artists would be unable to sell their music in such an environment without enforceable copyrights. Our model assumes that the most important determinants of CD and copy demand are consumers' tastes and transaction costs of copying, CD prices, and the substitutability between CDs and copies. We hypothesize that Internet file-sharing has been undertaken by both consumers who were previously not in the market, and by those who decided to copy rather than buy. In regard to firm strategy, the model suggests that labels could increase the sales of CDs by trying to increase consumers' taste for music, perhaps by reducing the price of CDs. Our model also predicts a positive relationship between artists' optimal share of album sales and their bargaining power, as well as a negative relationship between artists' optimal share and their risk aversion. Since lowering the reliance on labels for distribution would increase artists' bargaining power, our model predicts that artists' share of profits should increase as legitimate digital distribution gains prominence. We also provide empirical testing of our hypothesis that some music file-sharing has been done by consumers frequently not in the market. After examining consumers' expenditures and aggregate industry sales, we are unable to reject our hypothesis