I've had many opportunities to play with Windows Phone 7 and like three different devices sporting Microsoft's newest mobile OS. And it's quite good. Needs more work but it'll get there. But at this rate, even if it does "get there", it'll hardly matter if no mobile warrior is buy it or not many folks using it to make it.
This is where if Microsoft gives it away for free, it can really hit Google's Android in a place where it hurts and maybe even take the step after that to go after the iPhone.
First, by making it free, it negates the main advantage that Google's Android have - that it is free. I don't know how much Microsoft charges for it but I don't think it can be all that much. And given that so far only 2 million WP7 devices have shipped (not sold as Microsoft claims), it isn't much part of Microsoft's last quarter profit ($6.6 billion) if at all or a measurable amount of the $19 plus billion in revenue. So why not give it away?
Second, Microsoft can stipulate that if they take WP7 for free, they must use Bing as its search engine. This is something that Google cannot make Android device makers do because Google has said that Android would be open-sourced and free to use. Right now, some Android devices sold on Verizon Wireless are using Bing as their default search engine.
Third, Microsoft can try to reclaim lost revenue of giving WP7 away for free by typing more of the OS to other more profitable ventures like Windows 7, Xbox initatives, and Office. Plus, Microsoft is investing a lot in cloud services. If Redmond can create a coherent ecosystem, it stands to gain a lot. Plus, it will be able to put a hurt on Google.
The next step, Microsoft should work on its own hardware just like Google did with Nexus One and is doing with Nexus S.
This is my prediction. Microsoft will continue to upgrade Windows Phone with more features to catch up to Android and iOS. And it can do so quickly. But by that time, it might not matter. So I think Microsoft will let WP7 loose. Microsoft will handle all the development and recoup the costs and one day make money through ads and services linked to other Microsoft products.
I don't think it has any other choices if it wants to stay relevant in the mobile market.