The only problem is that your 2 factors are flawed.

The 360 while originally smaller than the PS3 is filled with empty space.  Plenty of room to reorganize and shrink things, unlike the PS3 which has always been packed full inside.

Also, heat was only an issue because of the stupid layout of the 360's internals.  No fan blowing air over the heatsinks.  A DVD drive RIGHT above a burning hot GPU, and only a weak/loud exhaust fan.  The 360 slim fixes this a lot by combining the CPU/GPU under one heatsink and puting a fan on top of it (hopefully, if the leaked photo is any indication).  The mobo shrank by multiple inches both horizontal and vertical.  If anything, shrinking it is going to help the heat situation a lot more.

Now, as to why this will be a big deal.  MS has already said they are treating Natal as a whole new system launch.  Expect to see a rebranding with a humungous advertising campaign behind the 360 this fall.  MS is the king of advertising and I expect the 360 slim to be a huge hit with Natal.

The truth is, there is really nothing Sony can do to counteract it, if MS does all of those things at once, just like MS couldn't counteract the pricecut/slim announcement from Sony.

A lot of people don't want to believe it, but Natal will probably be huge, and Move wont. The reason is, to the main stream, Natal is something different, and gimmicky, and new. The Move isn't. It's just like the Wii remote, and the main stream won't be able to tell a difference. If anything, it'll actually bring about negative press in a lot of circles.

I predict that Natal will have a lower barrier to entry, and a higher marketing push, along with a lot of gimmick-sales, plus be bundled. It's gonna move a lot of 360's in comparison to the Move.

Sony is going to do something with 3D. That's a non-factor, really, due to barriers to entry, and its advantages will be years away.

Sony has a lineup, Microsoft has a lineup that is just as strong. That's debatable, and each console has a number of AAAA and AAA franchises hitting this year. AAAA being Halo Reach and Gran Turismo(the extra A implies the console moving factor).

Sony could easily 1up any price cut by MS, because it costs more, and has more room to trim.

What Sony can't do, is counteract a 360 slim.

If that happens, there is no counteracting it. You would piss off your fanbase with another redesign at this point, if you're Sony, and to top it all off, MS has the chance to shed the stigma of the "RRoD" console. A lot of gamers didn't buy a 360 because of that, but if MS pushes the console as a cheaper version of the 360, and advertises decreased heat/hardware issues, the improved 360 will sell very well. It will be even more of a boon than the PS3 slim, which was touted as having no advantages over its predecessor(an already great machine) besides size.

The 360 isn't a "great machine" it has bugs, and it's got a slow, buggy interface. The RRoD issue would be easily fixed on a redesign, if nothing else, change the colors of the lights, and design it with modern cooling and a different case design.

People will pay 199 for it. A lot of people.

This is probably the biggest year MS has had since the launch of the 360, I agree. Assuming they follow through with our speculation here, the PS3 can't "counter" it, like the 360 couldn't "counter" the PS3 last year. You can only throw everything you've got at somebody once, and MS chose to do it the year after Sony did. Good move, but expected.

Sony doesn't have to counter anything, not every move another company makes need to counteracted, and as far as I know, isn't Move coming out before Natal?

Has there been any games showed on Natal other than Tech Demo's? Would be interesting to see how it works...

Natal is a hit or miss, until further game announcements.

 shrinking the thing will help the heat situation?  wtf?

Yup.  Anyone with good knowledge of PC components and how heat moves combined with knowledge of the 360 components can tell you this.

As the 360 is now, all there are 2 chips with 2 heatsinks and tons of open space for heat to just sit and bake the 360.  The slim would drop it to one chip and one heatsink with better fan placement to solve those problems very easily.

No, it doesn't take a physics major to refute that but whatever

I'm sorry this must be above your understanding.  But trust me.  I know the 360 inside and out as well as how heat moves and have been building computers that produce lots of heat for many years.  I know what works best for moving hot air out of a system and the Slim would both produce less heat and move it more efficiently.

it's shrinking the dye and reducing power requirements that reduces the heat, not so much tightening everything up, by shrinking the dye and decrease power requirements, they are able to make the overall product smaller and more efficient therefore reducing heat sink size and fan size while at it. at least give a proper answer =P

we shouldnt be talking about a 360 slim until we know its actually coming, for some reason though i doubt that. could microsoft pull that off? i mean the 360's we have now cant even handle being turned on for an hour.