The move reduces the price of the Xbox 360 Premium model by $50, to $350, and follows a move last month by rival Sony to cut the price of its PlayStation 3 machine by 17 percent, to $500.
Faced with unexpectedly strong competition from Nintendo's cheaper Wii console, Microsoft is aiming at expanding the appeal of the Xbox 360 to an audience outside its core fan base of young men.
"As we look to the holidays we want to bring in more gamers and lower the price for those customers," the Xbox 360's group product manager, Aaron Greenberg, said in an interview.
"We're always trying to bring down cost of the box and...we always try to pass on the savings to our consumers. We feel like this is the right time to do it."
The price of the Xbox 360 Core, which does not include a hard drive, will fall $20 to $280 while the Elite model, which features a 120GB drive, six times the size of the Premium's, will fall $30 to $450. The cuts will take effect from August 8, Microsoft said.
Launched in November 2005, the Xbox 360 has gone 20 months without a price cut, the longest of any console in history. Sony's PlayStation 2 held its $300 price for 18 months after launching in the United States in 2000.
"It surprised me a little bit because there's not a whole lot of market pressure on them to lower the price," said Van Baker, an analyst with market research firm Gartner.
"Is it going to make an enormous difference? No, because when it comes to consoles, it's not the price that sells the console, it's the games that sells the console and from that perspective, Microsoft's in pretty good shape," Baker said.
The rising sophistication of consoles, which boast graphics performance that rivals personal computers costing several times as much, means manufacturers are more reluctant to drop prices. That's particularly true for Microsoft, which has yet to turn a profit on the Xbox business it launched in 2001 in a bid to challenge Sony's growing dominance in the living room.
By the end of June, Microsoft had sold 5.6 million Xbox 360s in the United States, compared with 2.8 million Wiis and 1.4 million PS3s--the latter two launched a year later.
Microsoft forecasts its entertainment and devices division, home to the Xbox, Windows Mobile and Zune digital music player businesses, to turn profitable in its current fiscal year after two years of losses totaling more than $3 billion.
The Redmond, Wash.-based company has forecast revenue at the division to grow by between 10 percent and 19 percent this year from sales of $6.08 billion in fiscal 2007.
Greenberg said Microsoft timed the price cut to coincide with the release of Electronic Arts' Madden NFL 08, the latest installment of the publisher's top-selling football franchise.
"Summer tends to be seasonally slow, but we definitely see a big uptick starting with Madden, and accelerating through the end of the year," Greenberg said.
Microsoft is also banking on the highly anticipated final episode of "Halo", its flagship game franchise, to be a major profit driver this year. The game hits stores on September 25.