This wouldn't have worked at all, just remember how the NES (more dominant than any PlayStation) started losing market share to the Sega Genesis. At some point better graphics, bigger games and more features start to draw in the hardcore. Many mainstream gamers (not casual, that's the new Wii market) pick up new systems because they are impressed when they see their friends (core gamers) playing them. I know that I got at least 10 people to buy the 360 and sign up to Live, and at least 3 people to buy a PS3 after they saw them at my house.
The 360 was getting 3rd party exclusives with or without the PS3, because it offered more opportunities than the PS2. HD TVs and broadband internet were also taking off, and the PS2 could never do much with either of these. Sony not releasing a new PlayStation would ensure that both MS and Nintendo would take away their customers.
A better idea would have been to release a PS3 with a DVD Drive instead of Blue-ray, a lower spec GPU and leave out things that are not necessary (card readers, wi-fi, bluetooth) for $299. If they had done this I can guarantee that they would have slit Microsoft's throat in sales, profit and 3rd party support.
Let Blue-Ray stand on it's own two feet, and not make gamers pay for it.
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