Netflix is not a replacement for a traditional pay-TV video service, nor will it be. It's really more of a premium channel like HBO or Showtime -- both of which already offer streaming for a similar price as Netflix. I see the industry going one of two ways:

1) Cable TV over Internet -- in this scenario your cable subscription just becomes an app that runs on a wide variety of devices. Watch live TV, DVR, on-demand, etc. with a user interface that is somewhat reminiscent of what exists today. Channels will continue to be bundled and distributed through cable providers (though I expect non-infrastructure owning companies will also be spun off or started up). This scenario is most likely as it is least disruptive to the financial structure that's been set up on the content creation side (also all the big cable/telco companies are building this already).

2) Dissolution of the "big bundle" -- in this scenario, the content owners just decide to skip the middleman and become more like Netflix themselves. For example, Disney decides to just offer their own subscription service for $12/mo which gets you ABC, ESPN and the other Disney channels. Bundling would still happen here, just on a smaller scale. This fundamentally changes the business model though, and it will take a long time for content owners to develop the appetite and model to assume the risk of running a consumer-facing service.

Until the last 2 years or so, the content owners have also been licensing content to Netflix at low prices -- nobody else was interested in their library content so it was a way to monetize the long tail. But now that Netflix has established that consumers are willing to pay for the content, the content owners are raising prices significantly because the content they own had more value than they initially thought. The existential threat to Netflix is not rising distribution fees, it's rising content licensing fees.

I am not disagreeing with you in general, but for me Netflix really could be a replacement for traditional channels. Not too OT: I am visiting my Dad and yesterday morning we saw the new Godzilla movie in IMAX 3D and later last night watched Hitchcock's "Dial M for Murder" which was such a better experience than Godzilla. Old movie/TV technology done artfully beats less artful tech. Netflix can deliver old and some new content cheaply and on my time schedule.

Yeah; there is more than one use case for viewing video, one of which is on-demand video. Netflix does really well there. But it doesn't handle "event" TV (think sports events or American Idol) or the "I'm bored and don't want to have to think about what to watch" use case. Those two are huge, and while I think that eventually those use cases will change generationally, the 30+ demographic isn't likely to change their viewing habits any time soon.

Suppose Netflix has profit P, and AT&T charges them X. Netflix has the option of not paying AT&T, which could cost them (P-X) and cost AT&T X. This gives Netflix leverage to get AT&T to lower the price.

Actually going through with this threat costs both companies money, so they will likely work out a mutually acceptable division of profit without doing so. However, if one company thinks the other is bluffing, they may try calling the bluff.

Also, this likely means more expansive for end users.

Exactly, see Pandora for a current example of this "just profitable to be in business" model.