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What is a codec?
A codec is piece of software which contains a coder-decoder algorithm for sound. Some people call it a coder-decoder while other people call it a compressor/decompressor. The coder (compressor) is used when creating the sound file, the decoder (decompressor) when playing it. I believe that Windows 95 comes with some simple codecs installed by default; other more sophisticated and more modern codecs can be obtained and installed as desired. In particular, you need to install the appropriate codec in order to play MP3 WAV files. Sometimes you can only easily obtain one half, the coder or the decoder, but the file is still called a codec.
Most programs which involve the use of sound in any way, such as games, CD Rippers, MP3 Encoders and MP3 Players install any codecs that they require automatically without you needing to be concerned about them at all.
For the curious, a list of currently installed codecs can be found in CONTROL PANEL > MULTIMEDIA > ADVANCED > AUDIO COMPRESSION CODECS. I would caution against modifying anything in this area of Control Panel unless you are an expert.