This would have certainly cannibalized a large chunk of their macbook sales. Why? Not everyone who buys a macbook NEEDS the HP and featureset those provide. But... they want (or are told they need) an apple so they buy one. Since many of Apple buyers tend to be relatively affluent, they're not cross-shopping the macbook with gateways (or netbooks). They're simply swiping their card and moving on.
In your scenario, these buyers may be wowed enough by the swivel/tablet feature (people still till this day ooh and ahh when I swivel my POS HP tablet around) to end up overlooking the $1500+ macbook for the (in your world) $700 iTablet The Mac Genius (wtf?) will come and try and upsell them on all the great benefits (many of which this 'casual user' will never realize) of the much higher priced macbook... but that'll only hammer home the sheer fact that they didn't really need the muscle of the macbook in the first place. "I really only use it to go online and check my email so... I think this one with its fancy swivel screen will do just fine." Suddenly Apples laptop revenues drop 50% because they wanted to get into the netbook business. Who were they really competing with? Acer/HP/Dell or themselves in this scenario?
Simply put... Apple wants its $8 starbucks coffee drinkin, mercedes benz drivin, abercrombie and fitch wearin customers to keep buying their expensive computers. Releasing something that satisfies their basic needs while actually being 'cooler' than the much higher priced computers Apple sells would be a recipe for disaster.
but like i said, and to some extent you did too, it comes down to basically how pretty and easy to use it is. the lemmings will jump off cliffs for it.
