Piracy isn't a "market", it's theft. The free market isn't "balancing itself" when everyone's using an illegal hole in that market.

But it is an imbalance in the market, though. You just have to add the hidden costs of each alternative.

Pirating has costs: financial, legal (chances of getting caught times expected fine), and personal (hassle of hunting down the right torrent). Netflix managed to strike a balance point: you had a higher monetary price, but the legal and personal costs were now gone from the equation.

With all the new competitors, both the price and the personal cost of watching the content you like has risen. The return of people to piracy is then a previsible result of this imbalance.

Quite. Legality is really not that relevant when you look at the problem from pure market theory.

The legality aspect does mean the piracy as a competitor has a weakness that can be exploited by other competitors — e.g., by lobbying for stricter laws or suing individuals, or by appealing to morality — but it is a competitor nonetheless, and acts as one.

Market theory must accommodate things like piracy, just like google considers fines just some risk in their practices.