what is lacking is simply an efficient means of charging people for music.
i think with the right system, musicians would actually earn more from their music and innovators could develop really cool tools and not worry about getting sued.
I think that selling merchandise is a great way to get income, a friend's band (who are a reasonably popular goth metal band) have just started doing this and it's working well for them!
I think it's worth noting too that with several years experience in the music industry* I found that most musicians I knew were unable to pay the bills by playing music, the only common exception to this was people playing in cover bands who tend to make more money than unknown original artists.
*I worked for Gibson Australia for nearly 4 years.
But we need to remember why this model works. Programming is a relatively highly paid job. A programmer who works for a decade or so can afford the opportunity cost of doing unpaid work. The average musician, on the other hand, works at a pub!
Second, look at who are the purchasers of software support. These are invariably companies with deep pockets. Had they not purchased the open-source solution (which is cheap on account of that good samaritan programmer's efforts!) they would have purchased the equivalent closed-source solution, at a greater cost. Compare this with merch in music: the customers here are just individual consumers. And the typical pattern here is you go to a gig, and the first chunk of your money goes to your ticket, next to drinks, and if you have money left over, then you might buy a t-shirt (I'm musician, and was told by a professional manager [she works for the company that manages Amy Winehouse] NOT to buy excessive amount of merch -- she said that it was the weakest link; the one thing the customers really could afford to do without).
I agree with your second point regarding the difficulty of making money doing original music. It really saddens me, but c'est la vie I guess: not everyone loves music, and live music at that, as much as me. Demand is what it is. But what really galls me is filesharing, because in that case, the price is artificially zero. It is zero because there is not property enforcement. And that, frankly, sucks.
I think the whole situation is made worse by 2 main factors:
1: A lot of musicians think that they'll get noticed simply by writing and playing good material. That is not enough. Most successful original bands really have to work to get noticed, it may take many years of constant gigging, demos and networking before anything happens, if anything happens at all...
2: The disparity between the well-knows and the unknowns: Like the film industry there is a huge divide between bands that are well known and the up-and-comers. This makes breaking in much harder because it's almost impossible to advertise enough to get noticed in the sea of advertising and hype spewed out by the big labels. This problem may start diminishing though if the traditional labels fall as hard as I'm sure many of us think they are going to...
And it's not that labels are inherently malicious either; another band I know, Lucky Elephant (http://www.myspace.com/luckyelephant -- check 'em out, really nice and melodic!), just got a GBP 15,000 promotional advance for their recently released album. The label told them straight-up that there was very little likelihood that they'd ever make their money back.
As for your point about the labels falling on their faces: I'm not so sanguine about the future here. In most declining industries, it's the market leaders that fare the best -- in the music business, the majors! The indies are the ones that are screwed, which is sad because historically they've signed the most innovative acts (e.g. Island pre-2000s). Universal music is the only major label to have increased its market share in the last five years. It is not in commercial danger to my knowledge, and is likely to survive the current recession. The same cannot be said for Domino (of Franz Ferdinand and Arctic Monkeys fame). My fear is that once all the indies are gone, we'll be left with p-p-p-poker face p-p-p-poker face ad nauseum.