Here's the whole idea (I know this because I used to review video games for sony and xbox websites)...
The XBox costs Microsoft approximately $500 to build. For Sony, they spend about $450 (mainly because of the RISC processor).
Video game companies make their money from the games and peripherals. See, video game developers (and people who make other hardware such as controllers, memory cards, etc) have to pay a royalty per game sold, plus they purchase a license to develope games on the console. They also pay for what are known as debug units, which are unsecured versions of the system (for Sony, the PS2 debug can cost as much as $1,200 each. Microsoft actually sends a PC based XBox which is a PC with XBox emulation) for testing and creating their games. Because these units are licensed (not purchased), they have to renew the license in which they pay an additional fee. So, Microsoft and Sony can loose money on the system because they make 4 times the amount lost per sale (this is why video game companies are more strict on game pirating than on stealing systems).
As for Sony, no sony wasn't stupid for dropping their prices. In fact, they were smart. Press releases went out a few months ago stating that Microsoft was going to drop their prices on the XBox. However, the money to do so wasn't there (before you say "Microsoft is nearly the richest company in the world!", you must know that the XBox devision is an LLC. This means that they make their own money and are not funded by Microsoft Corp... unless they are in financial debt). Sony got a hold of the press release and decided to drop their prices first, forcing Microsoft to drop their prices. Because of this, Microsoft got hurt in the short run because Sony can afford to give the system away for nearly free right now, as opposed to Microsoft.