I don't think the distinctions you are making between market segments really match the way "the market" actually approaches these purchases. The market for "MP3" players is dwarfed by the market for iPods, and recently, something like 50% of iPod sales are for the iTouch, which, in theory and practice is more than a music player. Up until this point the market for "tablets" has been dwarfed by the market for iPads.
It is undoubtable that there is a market for an iPad-like device that is cheaper than the iPad. As you note, such a thing isn't possible, which brings us to the Kindle fire. It is much cheaper, but it is cheaper in part because it is less "powerful," in part because the hardware is less "refined," but most of the reason it is cheaper comes down to the fact that it is smaller and sold for a loss. That it is smaller makes it, on the one hand, more portable, but on the other hand, less good for many types of reading and interaction.
How will people feel about those tradeoffs. You seem to think that a lot of people will find them compelling because, well, why? Because of price? Price is clearly not the only consideration for people, as the iPod's success demonstrates. Portability? The iPod Touch isn't just a music player, and at least part of the market understands that already, as Apple will likely sell ~7M this quarter. It is more portable than the Kindle fire, and used for many of the same tasks. Taking both price and portability into account leads one to look at another alternative: the smartphone the consumer either already has, or is likely to acquire in the next six months.
People were faced with a similar choice a few years ago. Should they buy a netbook, or a "real" laptop. Netbooks sold well, for a little while. Some people loved them, others wanted to love them, but found their compromises too limiting. I borrowed from work, but it ended up just being a curiosity, and when I got an iPad, I realized it was better for both reading, because I could rotate the screen, and writing, because the on-screen keyboard could compensate for errors introduced by its small size in a way the netbook's keyboard could not. The netbook market is now in decline, while the market for the iPad seems to exceed Apple's ability to supply them.
I don't pretend to know how this will turn out, other than to guess that Apple will continue to sell a lot of iPad's at a healthy profit. I also expect that Amazon will sell a healthy number of Kindle Fires, and its successors. Further, I expect that the gap between the capabilities of the Kindle Fire and the iPad will grow for the foreseeable future, as Amazon "spends" most advances in technology to lower costs, and selling prices, while Apple uses most to drive upgrades and maintain margins.