#3 is just wrong.
These guys want to make video games. Maybe that's enough to make it work and maybe not. Time will tell. But by the logic of #3 we should all just do whatever puts money in the bank. That argument quickly devolves into a lot of would-be entrepreneurs sulking back to jobs they vowed they would learn to live without or building companies that are temporary money making opportunities, not something worth the devotion required.
Most importantly, these kids are making games with traction -- 200k downloads in a week is very, very good, especially since they don't seem to be that focused on actually marketing their games. That means they've got some special sauce. Tweaking what they have to bring up conversions is a solvable problem. Finding pizza money is a solvable problem.
If they're broke and people are playing their games then that means their customer acquisition costs are basically zero (since they don't have any money for it anyway). They don't have to get conversions up that far to turn an acceptable profit (especially since these guys apparently live on peanuts).
"You're competing for the business of toxic people who hate paying money" -- that's simplistic to say the least. I don't want to bother to dig up numbers but plenty of money is spent on games on mobiles and everywhere else. If you want to generalize that way you might say that about the whole mobile "app" market and the drive towards free or $.99 -- people expecting a lot for nothing -- yet it's still a thriving industry. If you're talking about the freemium or f2p model (in apps or games) it's not like the concept was invented by Zynga. The fact that freemium works was discovered -- it's a model the market supports and supports well.
"Well-funded corporations (which have high production values and effective, ruthless monetization)" -- high production values, especially on mobile where AAA graphics and open, 3D worlds aren't possible or even desirable, is not the issue it is on the consoles and PCs. Plenty of successful games are relatively simple 2D and have limited content. High production values in those cases can be measured in thousands of dollars, not millions. Ruthless monetization? What difference does that make in terms of competition, especially since we're talking about "well-funded corporations?"
If you're not that familiar with the market, pick up a big EA title and then play something like Tiny Wings. Which one was more fun? What do you think their comparative budgets were?
The "big corporations" -- EA et al I guess you mean -- were slow to move to this newest mobile market and have had a hard time making games people really like. They make up for it with marketing spend, but it's not like people aren't playing games like Tiny Wings because they can't pull themselves away from Mass Effect: Infiltrator.
If you mean mobile publishers like Chillingo et al then there's absolutely nothing stopping these guys from having a publisher like that pick up their game. There are pros and cons to doing so, but I doubt these guys would have any problem finding a publisher with the number of d/l they're getting.
"And amateur hobbyist artistes (who have "that vision thing" and are willing to starve to deliver it for free)." -- I'm not sure who these people are, but if you mean part-time developers flooding the market with low quality, free games, that only hinders visibility in the app stores. App store visibility as a sales tool was a fluke of the birth of these app stores and is now gone, never to return (although people are still seeing those effects in the Android markets). The amateur, as in most markets, has very little effect on the market as a whole.
If you're talking about developers with vision -- say the developers of Braid or World of Goo or say Notch -- these people don't work for free or hurt the industry. I'd say they elevate the entire state of the industry and turn more people onto games.
These guys should definitely learn the business side of what they're doing but it sounds like they absolutely should not stop making games.