Bitcoin is only a medium of exchange when merchants accept it and hold onto it. Right now merchants are dumping bitcoin for dollars, so its not being used as a medium of exchange. This btw. also throws the transaction cost benefit argument right out of the window (spread).
Now will merchants ever accept bitcoin and hold onto them?
No.
1) This is where you lost me. The merchants don't have to hold onto the BTC for bitcoin to have been used as a medium of exchange. The BTC purchaser exchanged their bitcoins for a product regardless of the actions of the merchant after the fact.
2) The idea is that at first most merchants immediately convert 100% to fiat currencies as hopefully more and more merchants adopt bitcoin (users of bitcoin driving the economy forward). At some point enough players are accepting bitcoins for payment that some merchants can afford to keep some percentage of sales in BTC to then pay suppliers or for services necessary for their business (merchants driving the economy forward). This then cycles and continues to grow the bitcoin economy in a positive re-inforcement loop that ideally ends with majority of participants only converting small percentages to fiat or none at all. It all has to start where we are now though.
Not to say that things will actually evolve like that, nobody knows how far this new economy will grow. However I think it's a bit myopic to completely rule out fiat convert merchant adoption today as any sort of potential progress and conclude it's game over. This is the first part of the process, we'll know if it works or not with time.
1) If you sold your bitcoin for dollars and used dollars to buy from the merchant would you qualify bitcoin as a media of exchange? Of course not. Now if the merchant does it for you because he does not want your bitcoins but dollars its the same scenario.
The merchant accepts bitcoin not because he wants bitcoin (again he dumps for dollars) but because he knows that bitcoiners are wealthy customers that would like to transact in bitcoin and that there is little competition for these customers at the moment.
The dumping of bitcoins by the merchant creates transaction costs (spread) that makes transacting in bitcoins expense.
thus potentially leading to the positive reinforcement cycle I've laid out in my last comment.
On top of that coinbase converts first million in sales for free so no "spread". From what I've seen even the other services that charge do it for fees lower than CC processors anyway.
2) No its not a gradual thing. You either hold onto bitcoin or you dont. Again the merchant can profit by having wealthy customers with no competition. He has not endorsed the use of bitcoin as currency unless he holds onto it.
There is a huge psychological hurdle to accept bitcoin, because bitcoin itself is not valuable. I explain this in more detail in this thread
https://bitcointalk.org/index.php?topic=364207.0.
B) Of course it's a gradual thing. It's taken years to go from 0 merchant adoption to where we are now. Are you telling me that assuming continued growth and popularity of bitcoin people won't continue to feel more and more comfortable holding on to it? It's what has been happening so far. Some merchants didn't accept or hold bitcoins that do now, it's only a question of whether this trend continues or not.
Also the decision to convert sales to fiat or not is not a binary one. You can set a sliding scale of whatever percentage you want converted for each transaction.
A) No. Accepting bitcoin for payment means holding onto them. The merchant has already calculated the average spread costs and priced these costs in his products. If you buy with bitcoin and calculate all the costs (spread buying spread selling for dollars) you will not be competitive and thus bitcoin cant become a medium of exchange as its only benefit are its transaction cost. Thus merchants dumping means the rejection of bitcoin.
B) Its not a gradual thing. You either decide to convert X amounts of dollars into bitcoin or you dont. You either hold dollar or bitcoin.