Generally speaking, a dual layer DVD will provide enough space. The only caveat will be multiple game discs for those FMV happy RPGs. If I'm Microsoft I'm going to do a cost/benefit analysis and ask myself whether the extra storage space of a new format is worth a $100+ premium on the console when most developers won't need the extra gigs.
The problem with going to a format like flash memory or any kind of proprietary format is that the console ends up taking a step backward. If you go with DVD you might not be able to say the consumers can watch movies in the newest high tech format but you can at least say that they can play most of what they've already got and the new machine either exceeds or matches the last one in every category. Taking away DVD playing capability will appear to be a huge step backwards when your last two machines were able to do it just fine.
Admittedly, I don't think many people are wanting of a new DVD player. But while it is highly unlikely that it would be a deal breaker for most people, from a PR perspective it would sound a lot like what Nintendo and Sony have been doing with their handhelds as of late with this zero sum game of "get this but lose that."
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