Yes, but even if you can decode at 720p or 1080i, you're still displaying it on a screen that maxes out at 480p.
If you have Blu-Ray at home, you likely aren't going to want to buy the same movie on DVD as well, and transcoding the videos to 800x480 could be time consuming (and illegal in the US). Only some movies come with both types of discs/dual discs.
Matter of convenience, and it is higher res than 480p, just not much higher.
I've seen 720p decoding using commercial codecs on the same chip that the Pandora has, so 1080i might be feasible.
True, but those are optimized for playback files. Playing back from a Blu-Ray is far more intensive, much like how streaming video is more intensive than playing it back locally.
The overhead of playback from Blu-Ray shouldn't be that much higher than a file stored on other media. I'm guessing by streaming video, you mean web streaming like Youtube and Hulu, the reason that takes up so much more processing power is because Adobe Flash is horrible at video playback and doesn't leverage much hardware acceleration. The same video, even being streamed, played through a dedicated video player like mplayer will take up a lot fewer resources and probably play better too.