Blu-Ray might not be ideal, but DVDs simply won't do. In the way you're thinking, what would've been wrong with CDs? Even though a dual layer dvd is 8.5GB, the 360 only supports 7.5GB. Now it wouldn't be a problem for sequential games like RPGs where disc switching is fine, but this won't do for open ended games. I definitely don't want to see innovative games being restrained due to disc space.
For example, very few games have native 1080p texture this gen. Imo, it's because 1080p needs more storage space as well as a drive that loads those texture fast enough. The PS3 has enough space, but the blu-ray drive is 2X and too slow to load those textures. In the next gen, it won't be the case anymore and DVDs simply won't do.
But, on the other hand, I totally agree with you that Microsoft will not use something for which they have to pay royalties. Personally, I can see MS going back to cartridges with new flash technology inside. Imagine playing your games on a 16GB flash usb key at USB 3.0 speed...That would be awesome imo.
"In the end, you're always on your own."
~ Squalll Leonheart
