In this context, a regenerative Merlin 1 (hereafter refered to as Merlin 1x) may make sense because it may improve safety, reliability, and operational costs, and the cost of those improvements may be realistically amortized over dozens of launches. As the engine cycle is more efficient, a small increase in Isp and perhaps thrust is likely.
So why Merlin 2?
Elon keeps saying that Merlin 2 will be the biggest single thrust chamber around, but smaller than the F-1. Presumably, he is implying that it will have less total thrust than existing multiple thrust chamber engines, in particular the RS-180 (2 chambers, 4152 kN). That puts a fairly tight bound on the size. Here's a list of the biggest current engines, by thrust per chamber.
|Engine||thrust per chamber||Isp||Vehicle|
|F-1||7740 kN||265 - 304||Saturn V|
|RS-68||3312 kN||365 - 420||Delta IV|
|RS-24||2278 kN||363 - 453||Space shuttle|
|RD-180||2076 kN||311 - 338||Atlas V|
|RD-171||1976 kN||309 - 337||Zenit|
|NK-33||1638 kN||297 - 331||N-1/Kistler|
|Vulcain 2||1300 kN||318 - 434||Ariane 5|
Taking Elon at his word, Merlin 2 will have between 3312 and 4152 kN of thrust. Call it 4000 kN, 17% more than the Falcon 9 first stage.
What can SpaceX do with this engine that cannot be done with the Merlin 1B?
Improve Falcon 9 LEO lift to 11000 kg. That's not even close to lifting stranded Space Shuttle payloads, which is the largest obvious market in terms of LEO mass in the next four years. I'm not sure what payloads are enabled by a 9300 to 11000 kg capability improvement.
Cost-reduce the Falcon 9. I can't see how this can pay for development, unless the Falcon 9 is launching monthly by 2010. And a further (fractional) price decrease doesn't seem like it would stimulate the market any more in the near-term than the existing, bold, price statement.
Improve Falcon 9S9 LEO lift to 30000 kg. The promised Falcon 9S9 lift capacity (24750 kg to LEO) is almost exactly that of the Shuttle (24400 kg to LEO), but the shuttle payload bay supports its payload better. The additional weight of a frame inside the 9S9 fairing might make some Shuttle cargoes too heavy to lift. A Merlin 2 based first stage for the Falcon 9S9 would fix this. The trouble is, a modest increase in thrust from the Merlin 1x would also fix the same problem. And it seems the latter change would have to be less costly than a whole new engine.
If the Falcon 9S9, improved with either Merlin 1x or Merlin 2s in the first stage, took over a dozen Shuttle ISS launches, I can imagine that would be a high enough flight rate to pay for Merlin 2 development. The trouble is that if I were paying to lift a billion-dollar ISS segment, I'd prefer to go on a machine with engine-out capability at launch. Three Merlin 2s don't give you that capability, and 4 implies some kind of vehicle (and its development cost) other than a Falcon 9S9 with single Merlin 2s on the first stages.
Build a 100,000+ kg to LEO launcher. This is what you get if you want engine-out capability with Merlin 2s. This kind of capacity is not necessary for exploring the solar system with robot probes, or even for building big orbital telescopes. It makes sense only if you want to send people a long way for a long time. Elon Musk passionately wants to build this rocket, that's why it's called the BFR.
The only organization with any credibility talking about using such heavy launches is NASA, for use in sending people to the Moon and maybe Mars. The BFR is Elon Musk's statement that he wants to take over the U.S. manned space program's launches. The business case for Merlin 2 and BFR must fundamentally rely on the U.S. government privatizing a critical, and the most public, portion of the manned space program. A program which from its outset has been about national pride.
A more likely scenario is that NASA will spend billions developing its own HLLV in competition with SpaceX, in the process abandoning the Space Station and strangling SpaceX, and will end up being able to afford just two or three launches to the Moon before abandoning VSE for the next thing. The history of heavy launchers is not reassuring. The Saturn V (118,000 kg to LEO, $2.2B per launch in 2004 dollars) was launched 13 times. Energia (85,000 kg to LEO, $1.4B per launch) was launched twice.
If all this sounds dire, a more reassuring comparison can be made by considering what SpaceX intends the Merlin 2-based vehicle to cost. Mr. Musk has stated several times that the point is to get costs below $1000/kg. A 100,000-kg-to-LEO vehicle priced at $500/kg would be $50M per launch. The history of $50M launchers is much more attractive. The various Delta incarnations (~1300/kg to LEO, ~$50M per launch) were launched hundreds of times. Soyuz (7200/kg to LEO, $45M per launch) has been launched 714 times.
A big rocket at such prices would clamp Falcon 9S9 prices to $30M and also reduce the 9S9 flight rate, at which point the parallel-staged rocket might cost too much to fly profitably. So SpaceX faces a fork in the road: develop either the Merlin 2 or parallel staging, but not both. Parallel staging will cost less to develop, implement, and support, and the BFR will cost more but enable people to get out of low earth orbit, and perhaps convert the VSE from a boondoggle into a success.
And thus we get to the vision thing. Elon has at various times stated that SpaceX is out to make money, and at other times stated that the goal of SpaceX is to enable the colonization of space. Let me point out that you can make money first, and enable colonization second, but not the other way around.