Ugh. EVERY SINGLE TIME a new Apple product comes out some nut claims they'll have a smaller, cheaper one next year.
It usually doesn't work out that way.
Look at the iPhone itself. Remember how many rumors there have been about the iPhone Mini? But what did they do? They made the iPhone cheaper, then they kept the 3G around as a cheaper option when the 3GS came out. Cheaper, not smaller.
Remember the Macbook? And then the Macbook Air? Smaller, not cheaper. Cramming all that new mini tech in there cost them more.
How about the iPod Mini or the iPod Shuffle? They were smaller and cheaper, right? Yes, but they removed features. (Screen on the Shuffle, drive size, in the Mini.)
So when you look at all the things that could happen, I think the most likely choice is exactly what happened with the iPhone. When the iPad 2.0 comes out there will be 6 choices there but they'll keep 2 iPad 1.0 options on the store too, and they'll be the cheapest option.
I think that is far more likely than a device that's too big to be a pocket iPod but too small to make good use of all these wonderful new iPad apps.