Software isn't free either - you need people to write and maintain it. Hardware is often cheaper than people; there is always a balance to be struck.Servers aren't free and somebody has to pay for their upkeep. Perhaps Microsoft would bite all these costs.
However, is offering a streaming solution free for "backwards compatibility" an entirely sunk cost? The flipsides, that I can think off the top of my head, are that this provides you with additional opportunities for serving advertising to users, additional capabilities for selling more of the back catalogue of titles these users don't own, provides a userbase to espouse the virtues of a streaming solution to potential new users and also provides another hook for those that are on the fence for upgrading to the new hardware.