A 7 inch iPad would be a no-mans-land device:
Too big to fit in your pocket.
Too small to do anything production on.
What makes better sense is a 4.5 inch iPhone to cater to those who want a slighter larger device. But I do agree that Apple needs to fill the gap between the iPad and iPhone. I'm so used to the iPad that whenever I look at an iPhone I need to squint.
It's not a no-mans land device. I personally don't want one but I know many people who prefer a smaller tablet compared to the 10" iPad. The best way I can put it is that it's a one hand tablet. Most of the uses for the smaller tablet that I've noticed are books/internet/games. The 10" iPad has grown into a much more capable machine for production thanks to the apps but there's a big casual market that would like a smaller (and probably cheaper) iPad. I'm always surprised when I see people rocking the 11" MBA, a computer which I thought was way too small.