- Low end phones tend to be crappy. If everyone who gets a "free" low end Windows phone hates it because the phone isn't very good, they're going to trash talk Windows phones, even if the OS doesn't suck. Windows phones already get trash-talked quite a lot (I don't know anyone with a Windows phone that actually likes it). I don't know anyone with a WP7 device, so I don't know if it Windows still sucks on mobile devices, but there's already a bad reputation to overcome. I know you've addressed this with this sentence: "all this assumes that they can make a phone with cheap hardware which performs decently", but you can't really wave away the limitations of the technology. In a year, feature phone priced hardware will be smartphone capable...but Windows Phone will be even further behind Android by then.
- Windows Phone is not, as far as I know, a resource light OS. Putting it on an underpowered phone in order to keep the price really low is likely to lead to an even worse user experience than normal. Again, trash-talking end users would be the result.
- To make phones cheaper than Android phones, Microsoft would have to give away the OS for free, and try to make the revenue back through app store purchases or something. Microsoft doesn't have a history of giving away the razor and selling the blades at a steep markup (XBOX might be a counterpoint, since it reportedly was a loss-leader in the beginning).
- There is already a solid low-end smartphone market built on Android. The Optimus line, for instance, is available for free with contract from several providers, and for under $200 without a contract, and is a very serviceable smart phone; roughly comparable to a Nexus One, though not quite as nicely constructed. With a contract, even the iPhone is now close to free ($49 for a 3GS).
Feature phone users have already mostly begun migrating to smartphones. The only people I know who still use dumb phones are people on pay-as-you-go plans, that didn't offer smart phones when they bought their phone a year or two or three ago. Smart phones are now common on pay-as-you-go carriers, and most of the people I know on those plans are upgrading or planning to upgrade in the next few months.
So, to summarize: Beating Android to the bottom seems untenable. Beating Apple for the aspirational market seems untenable (since nobody aspires to use Microsoft, as it was historically the value choice). Microsoft needs to find a niche in the smartphone market, but I think all the good ones are taken. Blackberry had a good one in the enterprise market...but they've lost it by falling so far behind technically. Maybe Microsoft can win in the enterprise niche and fill the hole probably left by Blackberry (though both iPhone and Android are reasonably capable of serving in that role, neither has focused on it).