Even the people running the richest tech companies are awestruck by Web 2.0 valuations. Microsoft (MSFT) boss Steven Ballmer, who sat down with BusinessWeek editors and writers hours before Google (GOOG) finalized its $1.65 billion purchase of YouTube, questioned how the online video service could fetch so much. He also talked about Microsoft's video-game and digital music business, as well as the new breed of competition the company faces. Here's an edited transcript of the conversation.

What do you make of the deal between Google and YouTube?

[You've got to ask] could Google do whatever it is they're hoping to buy without paying $1.6 billion? Is YouTube really some permanent, long-term thing, or is it a fashion? I'm not saying it is a fashion. But every time we do valuations, I wonder if we can afford to keep this hot for 10 years. I'm sure somebody at Google has got to do the same analysis, because even $1.6 billion is more than 1% of their market cap.

Is there a business model?

Right now, there's no business model for YouTube that would justify $1.6 billion. And what about the rights holders? At the end of the day, a lot of the content that's up there is owned by somebody else.

The truth is what Google is doing now is transferring the wealth out of the hands of rights holders into Google. So media companies around the world are all threatened by Google. Why? Because basically Google is telling you how much of your ad revenue you get to keep.They better get some competition. Us. Yahoo! (YHOO). Somebody better break through or you can short all media stocks right now. As long as there are two, you can hold onto media stocks. Google understands that. And that's one reason why they're willing to lose money up front. Just look at some of these deals. That MySpace deal (where Google provides the ad engine for MySpace). We bid a lot of money on that MySpace deal. And we got outbid. We wanted to win that MySpace (NWS) deal. At some point, we said we can't do this. Now Google can afford to spend more than us and Yahoo because they have more people in their ad system, so they're getting better yield, effectively.

Getting back to the core question, it all depends on how that plays out. I am surprised that Google would pay $1.6 billion for it.

You're clear as a bell on the YouTube valuation…
No. I'm not saying it is overvalued. I'm not trying to say that. It depends on a set of factors. I'm not saying I wouldn't write a check for that amount of money. I might.

Really, even though there's no identifiable business model?

It is one of those things where you have to think. You can't punt either way. If you're asking me if I would offer $1.7 billion if no one else was offering $1.6 billion, no I wouldn't do that. On the other hand, if somebody is really going to offer that amount of money, you cannot reject these things. And I'm not saying that we are.

Take Facebook. Every month and a half, there's a rumor that it's going to get sold. What was the last rumor, a billion bucks? Is it worth a billion bucks? It hasn't proven to be worth a billion bucks. But it also hasn't refuted that it might be worth a billion bucks.

Look, there are only [a few] buyers who can buy anything over a billion dollars in this space. There's us. There's eBay (EBAY). There's Yahoo. And there's Google. I don't think there's anybody else. Even Amazon (AMZN) has a market cap of only $13 billion. I don't think they're going to do too many $1 billion deals. So you've got maybe four guys who will buy in that range. And there's the public market.

Things will be valued that way. And we will not be on the sidelines if we shouldn't be on the sidelines.

What do you think about Web 2.0 valuations?

There are hot companies, and there's everything else. The question is: What's the value of an eyeball? Take Facebook. If you knew for sure that you were going to have the kind of minutes of eyeball time on the percentage of college students that Facebook has today, for the next 15 years, it's an easy billion-dollar check to write, even though it doesn't have a business model that establishes it. If [Facebook founder Mark] Zuckerberg is going to grow older, he's going to lose his hipness. The site is going to be replaced by Facebook Prime, you know, the guy will be old. Pretty soon, he'll be 25. It's not like it's so sticky. College students churn every four years anyway. If it's that, it's not worth anywhere close to a billion.

We're excited about Facebook. We're selling all the advertising for it. We're more excited now that we're selling ads for it than we were before.

These are hits-based phenomena. Don't you and others have to monetize very rapidly before people shift onto something else?

If they are hits-based, which is the implication I've made here, and you pay a lot of money, you're going to have to move in, milk, and get out. Or, it may turn out that the money is in the infrastructure for these things. What is Google to MySpace? It's the advertising infrastructure. In some of these things, you'll have to decide, if you're the big guys: Do I want to play at the application level or do I merely want to play at the commerce and other platform level in a way that strengthens the rest of my assets and allows me to make money?

Explain how the business for Xbox changes from the first generation of the console to the current generation with Xbox 360.
Generation one was lose money—gross margin loss on the console for the lifetime. You've got to take a lifetime view. We did have a lifetime view that said if you add all the revenue from selling consoles and all the costs of shipping consoles, it was negative. It was a model that made that back on royalties and third-party games and our own first-party games. We actually thought we could pencil it out. We also didn't think we would lose as much money as we did because we thought we could charge a premium for a device that had a hard disk in it. But we could premium price to Sony (SNE) because we had a hard disk.

So this generation, we're not pricing to lose money on the hardware over the life. At the same time, we said we can't have hardware that we can't recover with the consumer. We couldn't recover the hard disk. So the hard disk is not mandatory in the 360. The most popular model has a hard disk. But no games require a hard disk.

Sony, in some senses, is in the exact same position we were in in the last generation. By sticking in the darn Blu-ray [high-definition DVD player] drive—and they are pricing to recover its cost—they are at a price disadvantage. If they move to match our price, they will lose a lot of money over the life of the console. And I'm not sure that Sony's P&L, frankly, would be able to tolerate that.

Microsoft has several high-level new hires. Are they changing the way you view the company?
Absolutely. Classically, we're the Windows company. When it provides $20 billion in profit, it's pretty important. But there's more diversity in everything that we do. I would have been hell-bent and determined six years ago to call Xbox the Windows Game Machine. We didn't. My natural tendency would have been to call [the forthcoming digital music device] Zune something that was related to Xbox since we have some consumer franchise. And yet, we're really building consumer marketing muscle. These guys are really educating us on new ways to do things. These guys are having a fundamental impact on me as well as the company.

Has the announcement of Bill Gates moving to his foundation in 2008 affected the company even though he's still there?

It has. People bring things to Bill for a lot of reasons. Escalation. Because it's nice to get a pat on the back. To get your butt kicked, but at least you can say you got it at the highest level. People see Bill for a lot of diverse reasons. And that doesn't disappear immediately. But we want to make sure that all of those experiences and everything employees need out of that gets picked up by somebody. We're working through that now.

Bill is very active, every day. But I'm telling him, "Now, what you really have to do is consciously think about where you're intervening." I think we've started on that. The fact that Bill was on sabbatical this summer made it a little easier to kick off because it's hard to break old habits.

Who are Microsoft's top competitors?

Guys who can touch us in multiple places probably matter more than guys who can touch us in any one place. And actually we don't really have our big competition from any one company. Any one company, we know how to compete with. It's alternate business models that we will have to embrace or compete well with. You give me any enterprise software company, O.K., and I'll say c'mon. We know how to go do that. We do do that. And we're really pretty good at it. We haven't gotten any worse at it. Boom. Boom. Boom. We know how to keep coming.

[Take open source.] Open source is not a new technology area. It was a new business model. In the last three or four years, we have competed very well by extending our value. Open source never goes away as a business model or competitor. We have learned how to compete with open source, and we will compete with it for the rest of time. But competing with open source will have to be something that's burned bright on the foreheads of our senior people.

The second big competitive force is advertising as a business model. Typically, people just want to reduce that to Google, and if you want to do that, you can. But it's do we embrace advertising fully enough as a business model? Because at the end of the day, anybody who comes at you with a cheaper-to-the-customer proposition, you got to worry about. And advertising looks cheaper to a consumer than something you pay for.

In the case of open source, we couldn't adopt the business model. We adopted a competitive approach that so far has worked very well. In the advertising case, we can embrace that model. We don't have to sit here and say it's that bad.

A third model I could sit here and write down on this list is that there are cases where software gets monetized through hardware. That's what an iPod is. iPod is a software thing. You just happen to collect the money on the hardware. You could say in China and India, it's unclear whether classic software will get paid for as much as advertising, hardware, subscriptions, etc.

So our ability to embrace and benefit from or compete with new business models—and I would say ad-funded and open source, more than this hardware thing—is more the way to categorize the key competitive dynamic for us.

Does Zune fit into the hardware piece of this?

Sure it does. Because the value of Zune, if we're successful, is all in the software. It's in community [the ability to share music and pictures with other Zune users]. I want to squirt you a picture of my kids. You want to squirt me back a video of your vacation. That's a software experience. The truth is, though, if it makes money, it will be built into the gross margin on the hardware. We'll figure out how to make money on the community perhaps later though advertising or other means.

How much money will you lose per Zune?

None. Apple (AAPL) put the hammer down there, dropped the price down to $249. If they had been $299, it would have been nicer. They have the advantage of scale. So we're at $249, too. We don't make a lot of money, not to start out.

Do you foresee any circumstances in which Windows Vista doesn't come out in Europe on schedule?

We're working very constructively with the Commission. At the end of the day, it's completely our choice when we ship Vista in Europe. We're having a discussion with the Commission that puts me, our management team, and the board in a better place to assess risk. If we think the risk is too high, we won't ship in Europe at the same time [as Vista's U.S. launch]. If we think the risk is low and manageable, we will ship at the same time. That dialogue is not done. Sometimes I think we're closer. And sometimes I think we're farther away. But sometime in the next few weeks we'll have to push the button because our partners—hardware makers and retail chains—need time to ramp up supply chains, marketing, and demand generation.

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