1  If you can play for free, how do they make money?

2 Not sure in this case, but other games make it so you can play for free but can pay for goodies that are otherwise hard to get.  Billy vs. Snakeman works that way.

3 What I've seen, typically, is that you can only play so far for free.  In Pirates of the Caribbean, you can't level up past a certain point; all skills can only go to level 2, you can only buy the weakest few ships, and so on.  In Wizard 101, you can only explore about half the first world--and there are 6 or so.  In Wizard, there's a hard limit--you simply can't enter some zones.  In Pirates, you can (IIRC) sail anywhere, but you'll get your head handed to you.  Free Realms caps your professions at level 5, and so on.
And of course there's other things--like in Wizard 101, you can get mounts that increase your ground speed quite a bit; but the ones you can buy with in-game money are ridiculously expensive because they're time-limited; the only perma-mounts require real money.