The 3.5 inch iPhone is highly functional. If there was a high end android phone at that size, I think it would be very popular. But there is something to be said for larger screens. Phones are now highly effective mobile computers, and we do more and more on them. A larger screen is a reasonable tradeoff for more and more people. One size does not fit all.
People say all the time that Apple is incremental and about stability. That's bunk. Apple disrupted the wireless phone industry with the iPhone. They didn't know if the iPhone would be a hit or not. They did not play it safe. Now they appear to be playing not to lose the game, and people mistake that for Apple's successful approach. Their success was changing everything, and they are still seeing the benefits.
I have no doubt a taller iPhone will still sell well, but android and soon Windows phones will continue to eat away at market share. Disrupting the industry again is a tall order, but I think they can be more competitive by releasing 2 sizes of iPhone. Why not? They do it with laptops and, if rumors are true, the iPad. There is a market for a larger iPhone, just as there is a market for a smaller iPad.