I wrote a Ruby gem[1] because it was a fun project. It was in a problem domain that interested me. A developer found the gem, saw that it would be useful for his project, and soon became my first client.
I tried the "MVP for $500" approach a few months back[2]. It generated some solid leads, but none of the projects were remotely as fun or as interesting as my current one. It's certainly doable to compete based on some perfect balance of price vs. quality, but I've found it's much more rewarding (mentally and financially) to compete by being the #1 expert of some piece of software a client wants to use.
Further reading:
Ruby dev Giles Bowkett wrote a pretty good blog post on lead generation for freelancers, http://gilesbowkett.blogspot.com/2010/03/programmers-what-to....