It would have been unlikely they would have adopted Steam's pricing structure with a mix of physical and digital distribution, but it would have been far more feasible if it was full digital.

Your comparison to similar markets may be valid, however if you're familiar with Steam (a far more direct comparison) and their sales, you'd know that radical pricing changes are possible. It's fairly common for major titles to go on sale for $2.50 - $5.00. I just got an email last week that said The Witcher 2 was on sale for $6.79.

I don't know for sure that Microsoft would have gone down this route, but deprecating physical media would have been a step in the right direction.