I really don't see this as a good idea. The best thing about the iPhone is all the non-phone stuff. The worst part of the iPhone, the phone. I try to use it as little as possible.
So, if you make a mini iPhone, you will be severely lessening the experience of all the non-phone stuff the iPhone has to offer, leaving just "the bad", the phone part. So, we'll have a device that is basically a severely limited iPod touch that you can't make long quality calls on (unless you're on Verizon I suppose, I'm on at&t).
As for Apple offering this to compete with the low-price Android phones, let's be rational here. One can buy a $49 8gb iPhone 3GS today. If people can't afford to pay out $49, they sure as hell won't be able to spend $30 per month on their data plan.
And besides, putting out a mini iphone will further fragment iOS devices, which is a sticking point when trying to criticize Android phones.