The cost of hashing does not increase from including another transaction in a block. A generator will always benefit from including a transaction no matter how small the fee. So the fees will approach zero (as, indeed, they are now) making block creation very unrewarding which will reduce the computing power providing Bitcoin its security to almost nothing.
Am I missing something?
Yes, the transaction fees and block reward are the 'seen' incentives for generation, but you are overlooking the 'unseen' incentives. If you were one of the very early generators of the system, and in another 2 years when the block reward steps down to 25 bitcoin each, how would you respond to the concern that difficulty (and therefore blockchain resistance to a brute force attack) would drop? If you had 10K coins (not unrealistic for some) and the market value were, say $5 apiece, would you sell all that you had knowing that the market value may crash and you might not get half of the net worth out of them, or would you buy and/or run a generator of your own even at a loss? If you have 50 bitcoins at $5 apiece, you probably wouldn't run a generator (unless you were one of these guys that has to heat their high latitude apartment with electric anyway, and therefore the cost of running a CPU/GPU at full tilt is negligible) but if you had a $50K net worth in Bitcoins you would have a strong personal incentive to protect that net worth. In a future with a successful Bitcoin, most generation would likely be performed at a net loss by persons or institutions with the most interest in Bitcoins security. After all, you might not think twice about $50 in your wallet on the nightstand with that one-night-stand, but what would you do if you had $10K in cash? Would you deposit that into a savings account at a bank with a $50K safe? If you do, you are contributing to the cost of that safe, even though your share may be so small as to ignore; but the bank still invests into it's own security at it's own loss.