How to make money on free seat upgrades?
Like on all other activities in a loyalty program. By incentivize travelers to spend more with the airline, either by devoting a larger portion (preferably all) of their travel spendings or to actually increase their travel spendings.
Even on the freeloading gold, who only does the bare minimum 4 segments/year and has zero intent to spend more with the airline, there is potential revenue for the airline. They get to sell the same economy seat twice on a flight with high load factor in Y and low load factor in J. And if they expect to sell a lot of J, then there just isn't any I availability.
If OP takes a look at other FF-programs I think he will find upgrades to be quite a common practice.