While Steam is the main platform to buy games om PC, it's hardly the only one. Microsoft could push their store more to gain some market share on videogame sales. They could also go the smartphone route of selling them cheaper, but with a Gamepass or other subscription included.

They have hardware, excellent infrastructure, tons of people, studios and talent, plus ungodly amount of money ... so what possibly could be missing? Ah yes, GOOD GAMES!

It boils down to basics. PS5 is pretty much XBSX + couple of excellent games. So why on Earth would you go with Xbox? I'll take this question even further. Considering that all of those games are (or soon will be) available on a PC, why would you even buy a home console nowadays? 

There are a lot of false premises and quite dubious cause-to-effect assumptions here.

What MS should do to remain competitive? that's quite obvious: continue to do what they are doing.

Microsoft has set the ground for years to be more competitive in the market and they're more competitive now than ever before.

If you don't see that maybe you focus too much on pure hardware numbers. This is not the right measurement in Xbox's case because, even if it's still a dominant portion of their gaming business, it's a segment they've untied themselves from.

Even before the ABK transaction completion, we were at a point where even with just ~55% of the number of units of their closest competitor they managed close to 70% of their counterpart revenue and with better profit margins leading them to produce even higher profits.

The claim that the market is not big enough for 3 players is misplaced, the market can accommodate more than 3 players and there are already way more than 3 actors in the market, and many more actors have recently jumped in with PC Handheld. Actors in the market engineer themselves to fit how they want and how they can. 

The challenge now is the decade-long stagnation of the overall market size while budget and development time continue to explode. And it's not about how to sell more consoles and take more share, it's the very concept of subsidized walled garden hardware that is now failing to adapt to current reality. Sony is currently selling what would have been considered a more than healthy amount of consoles and yet, by today's rulesets, it is not. It's not enough to sustain their development with satisfying profit margins. That's why they are now going to increase support for PCs.

In those conditions, my understanding is that MS is already well-positioned to play by the new rules that are unfolding and that PC support, GamePass, and day 1 titles are critical components going forward.