Because of this, witnesses often use a small 'price discount' to artificially lower the price of STEEM internal to the Steem blockchain
Do you mean that the price of steem on the internal market is based on witnesses price feed? If yes, then the price of STEEM is not dictated by the free market.
No, the price on the internal market is based on whatever market participants are willing to buy/sell at.
The blockchain has it's own internal price, which is different than the internal market price. The blockchain price is used to determine the amount of STEEM that SBD conversions produce, as well as how much SBD to pay out for author rewards. This price is set by the witness price feeds.
I think you are confused. There are two completely separate prices:
Price 1: The internal market price, set by the buying and selling of STEEM/SBD.
Price 2: The internal blockchain price, set by the witnesses price feeds.
There is also a difference between "converting" SBD to STEEM (done through the wallet, and takes 3.5 days), and "trading/exchanging" SBD for STEEM (done through the internal market, or through an external exchange).
Yes, that is correct.