My limited understanding is that the first transaction needs to raise a flag in order to allow RBF. Merchants that accept 0-conf TX could scan for the flag and wait to deliver their part if it is set. On the other hand I am not sure how ready merchants or even regular wallet implementations are.
Can anyone tell the major benefits of this update apart from what I understand is to help induce a free market for transaction fees. Won't it break the ability to accept zero confirmation transactions?
Nope. Those transactions are opt-in, meaning that if the transaction doesn't opt-in to use RBF, then it can't be Replaced later.
So this means that when a transaction is broadcasted it has a flag saying that RBF can be enabled, or that it can't?