Maybe it's less profit margin in favor of higher volume. Maybe it's a way to create a gateway device for bigger/better iPhones. There's a pretty decent profit margin on the iPhone, no? And I imagine 4" screens aren't in nearly as high demand... so I am sure that's also one area they are saving money. As is the lower spec'd front camera.
Didn't realize the front camera wasn't upgraded since they upgraded to the selfie flash. As for gateway devices…
No, I'm not worried in the least. As I posited in another post, I think this device is design for buyers on the fringe of Apple's consumer base: people that demand the legacy form factor, people that are low-turnover buyers (non-annual upgraders, which don't tend to be tech or spec addicts) and people are a deal hunters.
I would wager that very little R&D had to be done in developing the components to the form factor, so this is intended to be a moderate volume design that's intended to target the above groups, and possibly to grow the iOS install base among those still using feature phones.
Your reply is similar to the guy above about it being a gateway type device. I wonder how well that will work out for them. I work at a university and know for a fact that many of my student interns would leap at what is essentially flagship features and performance for $250 less, even if it is smaller. Why? Because money. Many women also want a smaller phone because hands. My wife will be getting this phone. Many of her friends have been holding out for a new 4" model using old iPhone 5 and 5s models. My boss only recently gave up on the 4" model a couple months ago and got the 6s. 35% of iPhone users still have a 4" or smaller device, so that's a lot of users who would consider it.
Another important thing to consider is that enterprise will likely go the route of the cheaper phone when offering them to employees. I mean what business wouldn't pass up an iPhone that has performance to easily last 3 years, maybe even 4, for only $399? Heck, even I'm considering going down to the 4" size again. I kind of miss it, lol. As I said before, I just have my doubts that they will upgrade it yearly, so it probably doesn't make much sense to switch to it for me personally on the iPhone Upgrade Plan. It also won't get the fancy new features, like dual-camera systems and such. Eventually the bezels will be reduced on my 4.7" model (hopefully they stick with something around this size) and it will be closer to the old 4" in height.
I wouldn't at all be surprised if this thing becomes one of the most popular iPhones ever sold.