Microsoft (MSFT 1.31%) recently announced the official prices for its Xbox Series X and Xbox Series S gaming consoles. The Series X will cost $499, while the smaller and less powerful Series S will cost just $299.

The price of the Series X wasn't surprising, but the Series S's low price likely stunned Sony (SONY -1.34%), which still hasn't revealed the prices for its PS5 and PS5 Digital Edition consoles. Let's discuss why Microsoft aimed so low, and how Sony might react to the Series S.

The Xbox Series X and the smaller Xbox Series S.

Image source: Microsoft.

The battle of the all-digital consoles

Microsoft and Sony both plan to launch two versions of their new consoles -- a larger one with an optical drive, and a smaller and cheaper model which ditches the optical drive in favor of digital downloads.

Sony's full-featured PS5 is expected to cost $499, and current predictions peg the PS5 Digital Edition's price at $399. However, the PS5 Digital Edition will sport the same hardware as its big brother, while the Xbox Series S will run on a weaker CPU and GPU with less RAM and storage. Both versions of the PS5 will run games at 8K resolutions. The Xbox Series X will also run at an 8K resolution, but the Series S will max out at an upscaled 4K.

For some gamers, the sacrifices the Series S makes might not be worth the lower price. But for gamers who don't own 8K TVs or many physical games and Blu-ray movies, the Series S might be an appealing choice.

Adjusted for inflation, the Xbox Series S will be Microsoft's cheapest ever gaming console. Aggressively undercutting Sony makes strategic sense, since Sony's decision to launch the PS4 at $399 in late 2013 gave it an early edge against the Xbox One, which launched at $499. Microsoft eventually matched Sony's price, but it's only sold 48 million Xbox Ones to date -- while Sony has sold over 113 million PS4s.

Setting firmer foundations for its digital ecosystem

Over its past three console generations, Microsoft expanded its gaming ecosystem beyond Xbox Live with digital downloads from the Microsoft Store; the Xbox Game Pass, which offers unlimited download installations of over 100 games for a monthly fee; and Project xCloud, which streams over 100 cloud-based games to Xbox consoles, PCs, and mobile devices.

Microsoft also blurred the lines between console and PC gaming by letting gamers stream their Xbox One games to Windows 10 PCs, and extending Game Pass to Windows games.

In that context, it makes sense for Microsoft to launch a cheaper, lower-end version of its new Xbox to strengthen that digital ecosystem. If Project xCloud catches on, the hardware gap between the Series S and Series X could become less apparent as players stream more games from the cloud.

How will Sony react to the Series S?

Sony and Microsoft traditionally sell their consoles at thin to negative margins, then recoup the initial costs by selling software and services. Therefore, it wouldn't be surprising if Microsoft plans to take a loss on each Series S sold.

The PS5 and the PS5 Digital Edition.

Image source: Sony.

But Sony is now faced with a difficult decision: Will it sell the PS5 Digital Edition at a higher price than the Series S, in hopes that its superior hardware will win over gamers, or will it match the Series S's price and sacrifice its profits to hold Microsoft at bay?

Like Microsoft, Sony also views its console as a launchpad for digital services. Sony's core platform is the PlayStation Network -- which provides digital game downloads via the PlayStation Store, cloud gaming via PS Now subscriptions, media streaming services via PlayStation Music and PlayStation Video, and a rotation of downloadable games, perks, and discounts through PlayStation Plus subscriptions.

What's at stake for both companies?

Microsoft's gaming revenue grew 2% to $11.6 billion in fiscal 2020, which ended on June 30, or 8% of its top line. Its growth decelerated significantly from the previous year, but the growth of its software services -- especially throughout the pandemic -- offset its slower hardware sales.

Sony's gaming revenue fell 14% to 1.98 trillion yen ($19 billion) in fiscal 2019, which ended on March 31, and accounted for 24% of its top line. It attributed that slowdown to slower hardware and software sales ahead of the PS5's arrival, and tough comparisons to the hit first-party games, God of War and Spider-Man, a year earlier.

However, Sony's gaming revenue surged 32% year over year in the first quarter of 2020, thanks to strong sales of The Last of Us Part II and the elevated usage of PlayStation services throughout the COVID-19 crisis. But based on the weight of its gaming business, Sony has more to lose in its upcoming clash with Microsoft this holiday season -- so it needs to carefully assess its pricing strategy against the Series S.

Sony's investors shouldn't worry yet, since it reportedly ramped up production of the PS5 earlier this year, but Microsoft has clearly learned from its mistakes with the Xbox One -- and it could cause Sony headaches by positioning the Series S as a loss leader for budget-conscious gamers.