If their home is "under priced" as you claim, then just sit back and watch it sell - probably with multiple offers - probably over asking price.
You can sit and watch that happen, or...............you can get in the game and compete with them.
Lower your price.
What they (or you) paid for the home has nothing to do with what it will sell for in today's market.
Their motivation to sell is certainly important, but....I would hope that you're equally motivated.
The fact that it is 500 sq ft larger than your home DOES matter.
How does your home "show" compared to their home?? That matters, too.
If you take your home off the market (don't see any reason to do that), you will still have to deal with their sale price.....if they ultimately sell for less than 500,000 it will set a "comp" for the neighborhood which will make it harder to convince a buyer, or more importantly, an appraiser, that your (smaller) home is worth more.