IF THE entertainment industry wanted an early warning of how filesharing over the internet was going to affect business, it might have been wise to check what middle-aged craft hobbyists and sock-knitting grannies were up to. By the time record labels had begun fretting about the impact of Napster, back in 2000, the business of needlework and knitting patterns had been left for dead: on peer to peer (P2P) sites, craft enthusiasts were sharing needlework designs and knitting patterns freely, and within a couple of years the industry's major players were brought to their knees, their businesses in ruins.

The same has yet to happen to the music industry, despite the fact that, according to estimates from European trade body the International Federation of the Phonographic Industry (IFPI), as many as 20 billion tracks were illegally shared in 2007 alone. It has left the industry in grave difficulties, however, after it first ignored and then struggled to adapt to a world in which the CD was no longer king, and in which live music now accounts for the majority of bands' - if not their labels' - profits.

The most stark example of the industry's woes so far is last year's £3.2 billion private equity buyout, headed by Guy Hands, chief of private equity firm Terra Firm, of EMI, once the self-proclaimed "greatest recording organisation in the world". Having failed to persuade one of its former biggest acts, Radiohead, to release their new album through the label, things got even bleaker last month when Hands announced that the company's recorded music division was going to have to shed some 2000 of its approximately 6000 staff and undergo a radical restructuring.

Elsewhere, there have been successes, such as Apple's iTunes, which now accounts for some 80% of legal music downloads in the UK (they sell, on average, 1.3 million tracks every week). But while digital sales are on the rise - in 2004 they accounted for 2% of the market, now they account for approximately 15% - they are not enough to make up for the shortfall in physical sales, which continue to decline at over 10% per year.

The film industry is keeping a close eye on things too. Broadband take-up keeps rising and bandwidth is becoming ever cheaper and faster. Virgin Media this week announced that it would increase the speed on its maximum package to 50 megabits per second later this year. This means that Hollywood is beginning to face the same challenges that have left major record labels floundering: P2P services now mean that, given a half-decent home broadband connection, you can have this weekend's box office smash on your computer in a couple of hours.

"You could say that technological advances have ruined the music industry," says Simon Dyson, an industry analyst for business intelligence specialist Informa. "It's easy to blame the labels for letting that happen, but in a way, there's not a great deal they could have done about it."

Dyson agrees with the suggestion that labels reacted too slowly, citing Sony - a company that, in addition to owning record labels, also manufactures everything from computers and stereos to CD and DVD burners, and thus should have seen the changes on the horizon.

Slowly, though, the industry is starting to adapt. Mis-steps along the way such as overly strict digital rights management (DRM) on legal downloads, which restricted what consumers could do with the music they bought, often tying it to one specific computer, are gradually being abandoned. ITunes launched with DRM, but is now in the process of dropping it. Amazon's new download service, currently only available in the United States, serves up DRM-free MP3s. And the industry is currently attempting to tackle piracy head on by going after such organisations as The Pirate Bay - which relies on P2P BitTorrent technology to make available thousands of albums, films, games and TV shows - rather than suing individual consumers, an approach which led to little more than acres of bad publicity.

Though film and television companies are facing many of the same problems, the picture is, according to Dan Cryan, an analyst with Screen Digest, a little less grim than the one facing the music industry. "People are becoming less wedded to physical product," he says. "Broadly, what drives online content sales is hardware platforms; for the domestic computer, people in general don't want to pay for content." However, if they have an iPod - and the newer iPods are geared as much towards dealing with film as they are with music - "they do start paying for content". The big question for Cryan is: "When will we start getting the widespread adoption of something that will get movies to where people want to consume them, which is traditionally through their television, and still have them pay for it?"

So, where do entertainment companies go from here? Some have suggested advertising-supported streamed music free at point of use for the consumer. Last week saw the launch of something similar when Qtrax debuted at entertainment industry conference MIDEM in Cannes. It, too, is proposing advertiser-supported free music, but downloadable through shared files rather than streamed online. Things quickly became acrimonious, however, with labels almost instantly denying that any contracts with Qtrax had been signed, and although the future of the service is now in doubt, the idea might still point the way forward.

Eamonn Forde, editor of industry publication Five Eight, isn't convinced. "Music for free is a tricky proposition," says Forde. "I don't think the industry is seeing it as the end solution to the P2P problem, but it is a means of coaxing people away from illegal services and getting through to them the message that there is a moral decision for consumers. People can go to sites like that with a clear conscience, knowing that the artist and the label are getting paid, but whether there's any advertising money there remains to be seen: that's the big equation."

Whatever the future of the industry, they need to take into account the major change that has come with digital distribution: people don't buy albums anymore. They buy single tracks. "The music industry was built on album sales," says Dyson, and if you wanted that killer track, you had to accept that it might come on an album packed with filler. "There's gong to be a 10-year realignment, with people cherry-picking singles or buying tracks they heard in a film or on an advert."

According to Bob Lefsetz, an LA-based lawyer who formerly headed the American division of Sanctuary Records, this is a problem. "An album is a viable thing; someone makes a decision to buy it and they lay down their $10. But if a person is buying tracks, they have to make 10 decisions to spend that same $10."

While dealing with this contraction of attention span on the part of consumers, the industry must do the opposite and expand its vision. The past 20 years have seen an ever-greater insitence on short-term rewards, as exemplified by the now-annual X-Factor race for the number one spot. Speaking at MIDEM last week, Laurence Bell, founder of independent powerhouse Domino Records (home to Franz Ferdinand and Arctic Monkeys), said that labels should be more willing to "make a sustained investment in their artists, helping them develop past albums one and two, rather than always spending their cash trying to sign the next big thing". Alongside this, labels are facing pressure to cut down the number of artists on their books. EMI, before Guy Hands took charge, had 14,000 artists, 85% of whom made a loss. The logic used to be that such artists were subsidised by EMI big-hitters like Coldplay, Radiohead and Robbie Williams. But by last year that business model was fundamentally broken; EMI reported losses of £260 million for 2006-07.

So-called 360 deals, like the one Madonna signed last year with concert promoter LiveNation, are a way for labels to claw back some of that disappearing revenue by giving them a cut of artists' live revenues, merchandising and sponsorship. But they're far from uncontroversial. "Certain quarters of the management and legal communities would see these deals as land grabs," says Eamonn Forde, "but there are arguments on both sides, and labels realise that they can't just take a standard contract and add a clause saying oh, and by the way, we get a cut of everything else as well'."

For Lefsetz, there are two factors to consider about 360 deals: "One, the big-time managers will not do it unless the cheque is incredible. Two, the newbies might do it, but are they even going to sign to a major label when they don't know if the label will deliver what they need?"

There are two things almost everyone agrees on: piracy isn't going away any time soon - Simon Dyson suspects that "we'll still be talking about it in 2015" - and labels will likely collaborate with internet service providers to clamp down on filesharers. Recent French legislation has already cut off the internet connections of copyright infringers, and the UK government has warned ISPs in this country that it too will legislate unless it does a deal with the music industry.

U2 manager Paul McGuinness put further pressure on the broadband providers when he waded into the argument this week, saying that they should delete subscribers who were caught uploading files three times. On the other hand, a decision by the European Court of Justice last week that ISPs could not be forced to give up the details of those under suspicion of illegal filesharing has cast doubt on the UK government's room for manoeuvre. In sum, however, Dyson still believes: "A clampdown has to happen in the long term, because otherwise the industry isn't going to survive."

Cryan is a little more optimistic about the prospects for film and television. "It's a great service, the quality will only get better, and it gives you an easy and seamless experience," he says, adding that American networks are finding the same model is working for them. "The moment you need an application to view content, it's a barrier to entry, so broadcasters have all gone with open web propositions, and for television at least, they're generally free."

If the television and film industry is coping better it is perhaps because unlike with music, they're still dealing in the same discrete bits of entertainment rather than having to deal with the decline of the album and the rise of the individual track.

Forde predicts that there is consolidation on the horizon, as music companies diversify their business models. "Some of the majors stopped calling themselves record companies a while back, and started saying that they were entertainment corporations, which is, I think, a sign of things to come.

"They haven't moved quickly enough for the times, but they're exploring what's out there. They've finally realised that putting out albums is not the be all and end all," he says.