The 7800 was designed to replace the floundering Atari 5200, and to once and for all re-establish Atari's market supremacy against the Intellivision and ColecoVision. With this system, Atari addressed all the shortcomings of the Atari 5200 - it had simple, digital joysticks; it was backwards compatible with the Atari 2600; and it was affordable.
The 7800 was the first game system from Atari which was designed by an outside company (GCC). (Later consoles also designed outside the company were the Atari Lynx and Atari Jaguar.) The system was designed to be upgraded to a fully-fledged home computer - a keyboard was developed, and the system had an expansion port (derived from the Atari 8-bit line's SIO port) for the addition of peripherals like disk drives and printers. GCC had also designed a 'high score cartridge', a battery-backed RAM cart designed for storing game scores. Unfortunately, Atari manufactured none of these accessories, and after the initial production run they also eliminated the expansion port.
The 7800 was launched in test market (southern California) in June of 1984. One month later, Warner Communications sold Atari to Jack Tramiel, who believed (along with most of the country) that the video game fad was over. He pulled the plug on all projects related to video games and Atari's existing computer line to concentrate all efforts on development of the new 16-bit line (Atari ST). The 7800 was re-introduced in 1986 after the success of the Nintendo Entertainment System proved that the video game market was still viable.
The 7800's technical superiority is debated still today. The architecture is essentially just an Atari 2600 with a slightly better CPU and an advanced graphics chip (MARIA). While the system could handle far more moving objects on screen (up to 100) than any of its competitors, its audio capabilities were inferior. To compensate, some games (notably ports from the Atari 400/800 computer line) included a GTIA audio chip in the cartridge. The 7800 was also more difficult to program than other systems available at the time, though this was tempered by the fact that so many game programmers were already well versed in the 2600.
The 7800 faced the severe software drought that would become the mark of all Atari consoles sold after the video game crash. Relatively few titles were released by Atari, many of them unpolished and lacking in features. And there was virtually no effort by Atari to recruit 3rd party developers.