1. the FREE 3GS/iPhone 4 is subsidized by the carriers so Apple will earn a profit.
2. People who are interested in a free phone (students, etc.) , aren't going to buy a $99 or $199 phone anyway. These are the same people who got a free (and crappy) Android smartphone because the iPhone was too expensive.
3. AT&T has been offering a FREE iPhone 3GS for a year now so this is not new.