20GB is more than enough if you just use your 360 for gaming. The only reason you would want 120gb HDD is for downloading movies, or downloading xbox originals (or you could just buy the original on a disc and not need the HDD space). So really 120gb is only needed if you download lots of films, fill it with crap and never delete anything.
Arcade games are fairly small, with most under 100mb each. DLC varies, but is usually well under 500mb, though a few go over.
Remember that anything released on Live will get more people buying it the smaller size it takes up - some people don't have a HDD, so making downloads huge it cuts them out of the market completely. MS wants to make money, so making downloads smaller is in their best interest.
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