It is not a race-to-the-bottom contest but expanding your market. Note that Apple is not only about iPhones. When they have a growing iPhone-user-base, their iTunes division and iCloud division will grow with it.
Actually it is. Well actually it is about hardware sales. iTunes is contributing only ~5% to the revenue while iPhone sales alone are over 50%. So giving hardware away for cheap and making it up in volume won't really work.
