I have seen some really horrible pictures on my Kindle 2, certainly something needs to be improved. Color would help. There are issues with regard to color that aren't usually mentioned. The really revolutionary thing about the Kindle is the free Whispernet. It takes more information to convey color than black and white -- therefore, more bandwidth would be used. Therefore, it would cost Amazon more.
Another revolutionary thing about the Kindle is battery life--this is what really makes the difference in a reader -- you don't have to worry about charging it all the time. However, I wonder if someone just made a classy reader that wasn't as thin as the Kindle and had more battery in it, even if it increased the weight. Then e-ink wouldn't be so important -- I don't find that much eyestrain as people talk about on regular computers. I've been reading for many hours a day on computers for twenty years or so, with no problem.
And for color, just allow the local ereader to change the colors produced -- instead of greys, maybe blues. You would have color, but the color would come from your reader, not from the publisher of the book. You would have a similarly limited range of color, but you would specify the colors. Maybe that will be the next step.
Or maybe dual screens are coming. You would have an e-ink screen and a conventional screen for viewing pictures. I could go for that...
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