Why not have the best of both worlds and open up another market?

Ask Fingerworks. They could have licensed their technology to other companies if they had wanted to and found other companies willing to agree to their terms. Evidently they found being acquired by Apple to be their best option. And Apple, in possession of the same information, declined to continue participating in that market. I don't see what's wrong with either company acting in its own interests on this. The market was apparently not a viable one, and both parties have profited enormously in spite of not being a part of it.

There's also an opportunity cost, because smaller companies cannot use this technology and innovate.

You're talking about opposed concepts here. Using somebody else's technology is not innovating, it's copying. It also has nothing to do with "smaller companies": Fingerworks was a very small company and somehow, in spite of your claims, they were able to innovate. And they acquired the original patents. Where we the cries of protectionism hindering innovation then? Why was it ok when they were in the way of others using that technology?

As I said before: had Fingerworks not been able to secure a patent on its inventions, Apple (or any other company) could have simply copied their technology instead of acquiring them or licensing it. Competitors would clone and drive prices down, established companies with greater manufacturing, marketing, and distribution capabilities would have crushed them in short order. And Fingerworks wouldn't have had any leverage against them except their potential value as employees. Is this not a worse scenario for small and innovative companies than the one where they have significant bargaining power?

Oh, but products do differentiate and technology does improve.

You've ignored the context. You specifically said clones, and I specifically used the word when to indicate that I was talking about some circumstances and not all circumstances. When products do not differentiate (i.e. when they clone each other), innovation stagnates. Why differentiate when you can just do what your competitors do, but cheaper? Why innovate when you can just tack on some blue LEDs and silver trim to differentiate?

When products do differentiate, innovation flourishes. (At no point was I saying anything like "all products do not differentiate" or "all products only compete on price", as these are obviously untrue.)

Note that I say nothing about the size of the company (it doesn't matter) or the value of the differentiation (different doesn't mean good).

software, unencumbered by patents

There are articles on HN about software patents on a daily basis, and their existence comes up in plenty of stories not directly about them, such as the arguments over HTML5 video codec support, wherein even the "patent free" Theora video format was developed originally by a small company (On2) seeking to profit by licensing its patented technology. You can argue that such innovation might have happened without patents, but you can't argue that they did.

Software is also covered by copyright, which you seem to have ignored entirely, even though it serves effectively the same function of preventing creations from being ripped off. Again, though: I was not talking about software at all, much less software in general. I was talking about hypothetical iPad clones, just as you were.

it's innovative because companies have to push the envelope and cannot rest on their laurels

Why would they if any invention they create is immediately available to their competitors? Doesn't that reward the strategy of simply waiting for others to invent and cloning them? Doesn't that make it harder for small companies to break into old markets new inventions, when the established players can simply rip those ideas off? Doesn't it eliminate one of the main reasons that a big company would ever acquire a smaller company? Doesn't that in turn drastically reduce the value of invention?