Edit: I'm wondering how this would affect the iPod Touch. Assuming they keep previous-generation iPads at the $399 price point, .... Maybe they'll phase out the iPod Touch?
This would likely be the new iPod Touch. Instead of thinking of it as a shrunken iPad picture a large iPod Touch. Only it drops the pretense of being primary a "iPod". As a handheld gaming and media browsing machine it is a big improvement over the limitations of the iPods smaller screen.
The Kindle Fire , Nook Tablet, and new Nexus 7" (and about 5-10 other tablets ) are all priced on top of the iPod Touch price zone: $199-399. That will have negative impact on Touch if it just stays as same price points and same substantially smaller screen.
The problem is those are all almost sold "at cost". The other move Apple can make it so retire the "last year's" iPad as an option and put the 7" in the upper half of the Touch's zone.
Apple doesn't need a "I can't afford an iPhone" device since the 3GS is "free" (with contract... still costs more ). The iPod Touch got almost "nothing" for an upgrade last year ( a difference case color). It wouldn't be surprising if Apple did something more than just bump the CPU/GPU core to an A5.
The bigger issue perhaps is what happens to iPod nano. If Apple used a price reduction on the Touch to "retire" that product then they could have a straightforward 4" , 7" , 10" line up similar to how the laptops go 11" , 13" , 15" .
The Touch priced below the 7" Android tablets would probably do substantially better. A 7" Apple tablet priced above the Android 7" offerings would make Apple happier ( they can probably get away with it. Just sprinkle retina and millions of apps in the hype ). Folks looking for lower cost book readers will likely be happier. ( Apple could more easily do a price point better than "last year's" iPad if the screen is smaller. ). There are full sized and paperback books in the printed book world. "one size fits all" probably isn't going to work in the eBook world.
It would be surprising for Apple to shrink the iPod nano done to $99-129 , move the Touch 'down' range in price (keeping the specs relatively constant), and slid in a new 7" screen.
The relatively weak move for the Touch would be to just simply track the "taller" iPhone screen that is predicted and some minor updates on CPU/GPU specs while sticking to the same price point. Eventually, some vendor will catch up on software/media store and wipe them out on price though if it stays stagnant on price and size. Most vendors are distracted with beating Apple on phone or large tablet. At some point someone with talent is going to recognize that the Touch is a weak point.
