MP3 is the file extension for MPEG, audio layer 3. Layer 3 is one of three coding schemes (layer 1, layer 2 and layer 3) for the compression of audio signals. Layer 3 uses perceptual audio coding and psychoacoustic compression to remove all superfluous information (more specifically, the redundant and irrelevant parts of a sound signal. The stuff the human ear doesn't hear anyway). It also adds a MDCT (Modified Discrete Cosine Transform) that implements a filter bank, increasing the frequency resolution 18 times higher than that of layer 2.

The result in real terms is layer 3 shrinks the original sound data from a CD (with a *bitrate of 1411.2 kilobits per one second of stereo music) by a factor of 12 (down to 112-128kbps) without sacrificing sound quality.

*Bitrate denotes the average number of bits that one second of audio data will consume.

Because MP3 files are small, they can easily be transferred across the Internet. Controversy arises when copyrighted songs are sold and distributed illegally off of Web sites. On the other hand, musicians may be able to use this technology to distribute their own songs from their own Web sites to their listeners, thus eliminating the need for record companies. Costs to the consumer would decrease, and profits for the musicians would increase.

[source: webopedia.com]