I don't think they really think about it as competing with other apps. Their main bread&butter customers are businesses, and office365 subscriptions make sense for businesses generally. And there is no real competitive app for business customers. (sure there will be exceptions, but you can always find exceptions to a general rule)
I don't think they're really serious about home users for Office anymore - at least not garden variety home users who don't already have to use Office due to their jobs. The free or very cheap apps already available have that market - why compete with them?
They probably figure those home users wouldn't pay unless it's in the single dollar digits, and why would they want to impact the price they can sell it to businesses for?? Why drop your price to $9 when you can sell it for $69?/yr? Do you really think they'd get more than 8 times the number of paying customers? I don't. Maybe they'd get 2 or 3 times the number of customers, but not enough to make up the difference.
Sadly this is how the Innovator's Dilemma happens... when you give up your lower-profit customers to disruptive competitors, but don't see them as real competitors until they keep adding enough features to be on par, and then it's too late.
The only unique advantage Office has is full file format compatibility - it's a huge advantage, but someone will eventually be able to do it. (but no, Pages and Google docs and so on really aren't there yet)