Microsoft's consumer PC OS market has been reduced to those for whom price is a primary factor in choosing between one product and another. A little reading between the lines would suggest that the same is also happening to their business market. People (business buyers included) who are more interested in productivity than per unit price are increasingly turning to Apple instead of any of the brands running Windows. Hardware quality certainly contributes to this, but the main difference between a Mac and a Windows machine is the operating system, and that's where the difference in quality is most stark. Since releasing XP, Microsoft has given every indication of being clueless as to how to proceed from there, whereas Mac OS X has seen significant improvement with each major update. Windows 7, due in October, will fix many of Vista's faults, but it is fundamentally the same architecture as XP (plus Vista's compositing engine), better implemented than Vista but otherwise much the same, rather like Mac OS 10.1 which was widely perceived as an apology for 10.0. (10.0, by the way, already had a compositing engine.)
Microsoft plans to make use of the window of opportunity surrounding the release of Windows 7 to pry the prices of the least expensive Windows machines upward. Certainly they'd like to have more for Windows 7 than they've been able to charge for Vista since its bubble burst, but they must also recognize that their hardware partners are in danger of going out of business, or at least of getting out of the PC business, if they aren't able to show some profit on their investments. So far so good, a little more margin will make all involved (except the consumer and price-conscious business buyer) more comfortable, but it will also further narrow the price advantage of Windows machines over Macs, and widen the price advantage of Linux-based computers.
So how much is a better Vista worth? How much can prices go up, on the merits of Windows 7, before the effect is to accelerate the rate of defections, to Apple at the high end and to Linux at the low end? 10%? 20%? Hard to say, but it's certain that they can't take a very large bite out of that $500 per unit premium Steve Ballmer claims Apple is charging before running into a wall. People will say to themselves "if I'm going to pay the price of a Mac, I might as well get a Mac!"
And, given that Windows 7 will be facing off with Mac OS X 10.6 (Snow Leopard), which is a bigger improvement over 10.5 than Windows 7 is over Vista, the vast majority of those who really give it a try will become loyal Mac users, with no thought of ever going back. Microsoft had best be careful not to do anything to interfere with the installation of Windows on Macs or (even more so) with the usability of the Mac version of Office as compared with the PC version, or they may end up losing the majority of their future revenue.
Unless they find a way to get more improvement for their development dollar, the unprofitability of further Windows development I've previously predicted will sooner or later come to pass, at which point Windows will become a static standard, updated only for compatibility with new hardware, if that. Microsoft may eventually be forced to release the source code to keep the platform viable as a foundation for their PC version of Office.