Xbox 360 Arcade needs additional storage to run latest update
The Xbox 360 Arcade unit, with its meager of 256MB of storage, always seemed like a rather cynical neutering of the 360 to try to superficially bring the price down lower than the Wii. Which it obviously was: if you are an Xbox 360 Arcade owner and want to keep up to date with the latest New Xbox Experience firmware, you will have to buy additional storage cards just to fit the software on your console. Yeesh. Do yourself a favor: buy yourself an Xbox with a hard drive if you're going to buy one at all.
Avatar Customization Requires 256MB of storage [Xbox 360 Fanboy]

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Incorrect. The update requires 128MB and 256 is the optimal amount of free space. Microsoft is apparently offering some sort of storage solution to people with Arcade units. Hard for it not to be as timely as Nintendo...
Update from the same source:
http://www.xbox360fanboy.com/2008/10/10/ms-to-offer-nxe-storage-solutions-to-those-in-need/
No details yet - but looks like MS is going to help people out who don't have enough space. Thats for people who have either no storage or a 64meg storage.
The update itself takes 128 megs of space, which is why the requirement was at least a 256 meg memory unit - it won't be using all the space though. Arcade System owners will be ok, they won't have a ton of space for game saves after but the update will fit. Core System owners (the much older, no longer sold SKU) who did not buy any extra storage or bought the 64meg card back when there was no 256meg ones, will need to take advantage of the MS assistance.
Buying an XBox with an HD vs an Arcade version is like a massive large steak vs a mcdonalds hamburger... its about cost for a lot of people, the console is great, but buying the ultimate editions of it you might as well spend it on a alienware computer instead.
$299 is a far cry from an Alienware computer, dude.
So much trouble for another piece of crap that will have a RROD in a year.
Spare 20gb hard drives can be had, used, for around $40 last I checked. Perfect for Arcade/Core owners looking to upgrade.
MS didn't even say whether its mysterious "storage solution" was going to be free or not. My guess is they'll offer 256mb cards for nominal cost plus shipping. They've done similar things for other peripheral offers in the past (eg, USB adapter, data transfer cable).
I heard rumor of MS giving arcade unit owners that have their serials registered the option of purchasing a 20 gb hd for 20 bucks or possibly a 512 card.