Let's say that down the road is a burger stand run by a retiree. Because the retiree has other sources of income, she need not sell her hamburgers at a price that would max-out her revenue. She sells her burgers because she loves to cook and likes having something to do with her time. Your argument as I read it ("everyone is made worse off by there being less of this superior output. The fact that you can get enough 'to pay the bills' is irrelevant") is that this retiree is harming the burger-eating community by reducing the incentive of restaurants to make better, cheaper burgers. This does not make sense to me.
Price points are shaped by the seller's financial needs, goals, and expectations, and sometimes those goals are capped at merely "pay the bills." These price points, regardless of how they were reached, influence the marketplace. Sellers who choose higher price points need to compete in other areas, thus enforcing *stronger*, not weaker, incentives to create higher-quality content. This is as true with creative and information-based works as with hamburgers or anything else tangible. The only difference is the information can be created and increasingly be distributed more cheaply than stuff that can be eaten or dropped on a foot.
This is the great thing about markets: they tend to self-equilibrate. If the amount of content supplied at a price of 0 is inadequate, consumers will be hungry for more content and will be ready to open their wallets, leading to a non-zero price. If, in contrast, there's a lot of content around for free, then it will be a struggle to get people to pay for your content unless it's significantly better than the free stuff. Which of these conditions will obtain is an empirical question that will only be answered in the marketplace. But there are good reasons to think that, for most types of content, the equilibrium price will be zero.
This has nothing whatsoever to do with whether any given writer, musician, or programmer is able to make a living, or whether his salary is a "living wage" with good benefits. If some people are willing to create high-quality content at very low costthat will place downward pressure on profits and wages in that part of the market. That's unfortunate for the people competing with them, but there's nothing unfair about it, and it doesn't really matter how people manage to provide so much free content—whether it's done as a hobby, supported by third-party charity, or thanks to a clever "free-based" business model. All that matter is that the content is being produced.
The concern seems to be that profits might go so low that nobody is able to produce high quality content at all. But this confuses cause and effect. To the extent that producing high-quality content is unprofitable, it's precisely because there's so much high-quality content being produced that it's pushing profits down. Obviously, it doesn't make sense to predict that in the future content will become so plentiful that no one is able to produce it any more.
You'll notice that you commonly hear protectionists make the same kind of argument about "unfair" competition from overseas workers: competition in industry X is causing job losses in industry X, so what if competition in general causes all of our jobs to go away? Back before he was shrill, Paul Krugman tackled this argument in one of my all time favorite essays. At bottom, the argument suffers from a fallacy of composition: The fact that more competition in one sector reduces jobs in that sector doesn't mean that more competition everywhere means everyone loses their jobs. Likewise, the fact that competition from the web is costing jobs in the newspaper business doesn't mean that the long-term result will be no jobs in the news business at all. Quite the contrary, the reason things are so grim in the newspaper business is that there's more and better content available from other sources. The newspapers' decline is an unfortunate side-effect of a generally positive trend, not a harbinger of future problems.
And just to be sure there's no misunderstanding: none of this has anything to do with copyright.
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