I think 1 is more common than you think.I think 2 is the most common and then probably 3
First, it comes down to the size of screen. With a 32" screen or smaller, viewed at 10ft and with average eyesight, you are barely if at all going to see the benefit of even 720p over even an averagely upscaled DVD (such as provided by PDVD8 ). Yes you can get up and stare at the pixels from 2ft, but most do not.
Second, a LOT of people, simply do not watch movies for the eyecandy. My wife is a movie buff, she has seen Blu-ray (including Corpse Bride as it happens) on a large, top of the line, well calibrated 1080p set and whilst she will admit it is "nice" she really would not care. Upscaled DVDs on our system are much better than the quality we have ever experienced in a cinema and that is frankly good enough for her.
Given most people's TVs, environment and level of interest I do not see them willing to pay any significant premium for Blu-ray. Players and discs need to get very close to DVD levels for mass market adoption.
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