The British mega-band Radiohead made headlines last month by releasing its new album “In Rainbows” exclusively for download on its website and allowing consumers to set their own prices. Such an unusual and direct challenge to the music industry instantly made headlines—but it may be a portent of things to come.

Nine Inch Nails has pledged to follow Radiohead’s example when its current record deal ends. Prince included 2.5 million copies of his new album in a popular British Sunday newspaper, and handed it out for free to attendees of his concert, much to the consternation of record executives. Madonna made news recently by signing with a concert promotion firm in order to focus on live performances, endorsements, and merchandising, rather than on traditional album sales. More and more, recorded music is becoming a mere promotional tool for other profitable musical endeavors, such as live concerts. If this trends gains momentum, it could spell the end of the music industry as we know it.

Radiohead has created the potential for a whole new system of music distribution in which consumers set the prices.

Much has been written about the impending demise of the large record labels, some of it exaggerated. But the numbers don’t lie: in the first half of 2007, CD sales were down by 19.3 percent when compared to the same period in 2006. As author Frederic Dannen has pointed out, music consumers have consistently chosen convenience as the most important factor in selecting a medium, and the industry has been extremely slow to catch on. No longer are consumers forced to purchase entire albums to hear the one song they like, nor must they purchase an expensive “CD single.” Innovations such as downloading of albums and cheap single-song purchases continue to chip away at industry profits. It started with Napster and other file-sharing programs (some of which were legal but most of which were not), progressed with the iTunes music store and Internet-based retailers, and has culminated with Radiohead’s online-only album release.

If the Radiohead model proves successful, it could mark a turning point for the big record companies. Though much-reviled, they do provide valuable services for many bands. They use their connections and expertise to advertise, secure distribution, and aggressively promote music heard on the radio and elsewhere. But now that Radiohead is firmly established, it has little need for these services. By cutting the record companies out of the process altogether, the band has reduced its initial production cost—which means cheaper music for the fans.

Radiohead has thus created the potential for a whole new system of music distribution—one that is controlled through a band’s own website—in which consumers set the prices. Indeed, Radiohead fans can pay whatever price they want to purchase a digital download of “In Rainbows.” Some may pay nothing for the record, but many will pay a price they feel is fair because they know their money is going directly to the band. Meanwhile, Radiohead is spared the typical advertising and distribution costs.

The Wall Street Journal has estimated that the average cost to deliver an album’s worth of music online could be as low as $3.40, compared with an average cost of roughly $6.40 to deliver it in traditional CD format. When using conventional methods, major label bands make roughly $1.00 per album sold. So even if the average payment for Radiohead’s new album is less than $5.00, the band could still turn a higher profit from its online-only release than it would have through traditional album distribution.

Record industry bigwigs have reacted to this turn of events with a mixture of skepticism and horror. Some have expressed doubt about its potential, pointing out that profits from successful albums are used to subsidize up-and-coming artists. But one executive at a big European music label told Time magazine that it felt like “yet another death knell” for the industry. “If the best band in the world doesn’t want a part of us,” the executive added, “I’m not sure what’s left for this business.”

What will be “left for this business” is the same set of choices facing anyone in a free-market system: adapt, innovate, or lose market share. Time will tell which of these actions the record industry takes.

Andrew Moylan is government affairs manager at the National Taxpayers Union.

Image credit: composite from photos by Michel Zappa.