512GB storage makes perfect sense, as the Series S is positioned explicitly to provide a next-gen-like experience, as in the capacity to run all next gen games, at a price point that is extremely competitive when put up against both the Series X and the PlayStation 5. It is a small, affordable console.
While bumping up the storage capacity obviously does benefit a digital system in the most obvious ways, it also bumps up the price. Microsoft want to service two purposes here; firstly they do not want to cannibalise the sales of their own Series X, a system targeting the enthusiast gamer while also going head-to-head with PlayStation 5, and secondly keep the Series S price as far removed from the PlayStation 5 as possible.
The psychology of marketing is well developed and Microsoft want to avoid the issue of a Series S being a "cheap system" that's still within the ballpark of the PlayStation 5. If the PS5 seems more expensive, but only just, customers will be more inclined to invest a little extra more for Sony's offering. The further the gap between the two the more readily the Series S enters its own market demographic with a greater probability of becoming the de facto entry level, customer friendly priced "next gen system".
The 512GB storage will become a problem later on for obvious reasons, but there exist solutions for this already. Delete old games to play new ones. Or, if needed, buy an external drive. Customers buying this system are not likely to be hoarding 20+ games a year with no intention to delete them. They're economically conservative and making fewer, more careful choices in software. And while buying an extra drive obviously breaks the bank, that's something that can be addressed later. Like..12 or 24 months later, which is immediately more appealing than having to do it right out the gate (eg: systems with no storage at all).
Releasing a system that is more generous in storage but increases the market price to a tier too close to the PlayStation 5 defeats the entire purpose of the Series S. It also puts Microsoft in a position where the only solution is to cut the price and make a greater loss. Releasing a very affordable system now with lesser storage space that can be upgraded later is a much more sensible solution that permits Microsoft to aggressively market right out of the gate. Storage is an easy problem to fix, with a lot more flexibility. Pricing your console into a market tier it cannot compete in is not an easy problem to fix.
