That's the way it works. Money from game 1 will be spent making game 2. That doesn't make game 2 free as they have the development of game 3 to fund as well.

From what I've gathered, the core game has been overhauled dramatically since it began. Expansions have pretty much always been premium content. I don't remember any exceptions. If a person is willing to throw away that much on a subscription to one game then the cost of expansions is pretty trivial anyway. To the point where it's irrelevant really.
You say that they make so much money from WoW they could release it for free - they could too. But by that logic they could also release Diablo III and Starcraft II for free as well. After all there's no doubt they could do just that.
The bottom line is: the bottom line. They need to justify all expenses. It's a publicly traded company and they can't be seen to be investing poorly. So while I'm sure Kotick would love to furnish us all with freebies, it's not going to happen while greedy shareholders restrain poor Bobby's philanthropy.

The difference between a game like Diablo and a game like WoW, is Diablo is a limited revenue stream, i.e. it only make money off the number of copies sold, while WoW is a continuous revenue stream, i.e. it continues to make money off of subscriptions well after the initial sale of the game. It makes sense with a game like Diablo to charge for the initial game as well as any sequels or expansions, it doesn't with a game like WoW (well, at least as far as expansions go, sequels are another matter entirely). The only reason to charge for expansions on top of the ridiculous monthly fee is unrestrained greed, plain and simple. It is a problem that has been growing in the gaming industry for years now (exemplified by Bobby Kotick) and the unbelievable success of WoW has only made it worse. The sad part is, we as gamers let this happen by accepting their greed as something we can't do anything about; the "that's the way it has always been" attitude. We used to have a saying at my old job "Just because we have always done things this way doesn't mean there isn't a better way to do it". We don't have to accept the status quo and we shouldn't simply settle for it because we think we are powerless to do anything about it. That's how people like Bobby Kotick get the balls to start charging $60 or more for a single half-assed PC game, then make it seem like he is doing us some kind of favor with that. We as consumers are the ones who should be responsible for restraining their greed when they lack the semblance of conscience required to do it themselves. Unfortunately, we have failed and continue to fail miserably at that with the continued support of cash whore games like WoW and SW:TOR.