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The MP3 lossy audio data compression algorithm takes advantage of a perceptual limitation of human hearing called auditory masking. In 1894, Alfred Marshall Mayer reported that a tone could be rendered inaudible by another tone of lower frequency. In 1959, Richard Ehmer described a complete set of auditory curves regarding this phenomenon. Ernst Terhardt et al. created an algorithm describing auditory masking with high accuracy. This work added to a variety of reports from authors dating back to Fletcher, and to the work that initially determined critical ratios and critical bandwidths.

MP3 is directly descended from OCF and PXFM. MP3 represents the outcome of the collaboration of Karlheinz Brandenburg, working as a postdoc at AT&T-Bell Labs with James D. (JJ) Johnston of AT&T-Bell Labs, collaborating with the Fraunhofer Society for Integrated Circuits, Erlangen, with relatively minor contributions from the MP2 branch of psychoacoustic sub-band coders. Much of its technology and ideas were incorporated into the definition of ISO MPEG Audio Layer I and Layer II and the filter bank alone into Layer III (MP3) format as part of the computationally inefficient hybrid filter bank,

In November 1997, the website was offering thousands of MP3s created by independent artists for free. The small size of MP3 files enabled widespread peer-to-peer file sharing of music ripped from CDs, which would have previously been nearly impossible. The first large peer-to-peer filesharing network, Napster, was launched in 1999.
When performing lossy audio encoding, such as creating an MP3 file, there is a trade-off between the amount of space used and the sound quality of the result. Typically, the creator is allowed to set a bit rate, which specifies how many kilobits the file may use per second of audio. The higher the bit rate, the larger the compressed file will be, and, generally, the closer it will sound to the original file.

An MP3 file is made up of multiple MP3 frames, which consist of a header and a data block. This sequence of frames is called an elementary stream.
Many other lossy and lossless audio codecs exist. Among these, mp3PRO, AAC, and MP2 are all members of the same technological family as MP3 and depend on roughly similar psychoacoustic models. The Fraunhofer Gesellschaft owns many of the basic patents underlying these codecs as well, with others held by Dolby Labs, Sony, Thomson Consumer Electronics, and AT&T. In addition, there is also the open source file format Vorbis that has been available free of charge and without any known patent restrictions.

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