Microsoft doesn't think "it is sitting pretty because Best Buy has a 17-inch Dell for $650." I can assure you that internal talks at Microsoft include very worried discussions about how they're going to deal with Apple's quickly growing market share.
Microsoft's response to "Macs are better" is "PCs are cheaper", not because they think more PCs will sell because of these ads, per se, but because they want computers to be cheaper. They want to frame the buying decision in terms of price so they can drive prices down further. Oddly enough, this kind of worked. Apple lowered their prices.
As Joel Spolsky says, "Smart companies try to commoditize their products' complements... Microsoft's goal was to commoditize the PC market." (http://www.joelonsoftware.com/articles/StrategyLetterV.html)
Microsoft does not think that it's OK to be inferior to Apple as long as they're cheaper. They just really really want computers to be cheaper. They always have. That's how they've made billions of dollars over the years. They tie the success of their software business directly to falling prices in the computer hardware industry. If they see any hint of that trend reversing (rising prices in hardware), they're going to fight it tooth and nail.
I think what they really need to understand is that the race to the bottom in the computer hardware market is generally over. We've arrived at (or near) the bottom. People can afford just about as many computers as they could possibly want now. If they want to further commoditize the personal computer, they should be doing what Google is doing and writing a stripped-down OS that runs on much weaker hardware but relies on the web for processing power. Insisting on machines that are both cheaper and more powerful than the PCs of yesteryear has reached the point of diminishing returns.