this is exactly opposite of what would happen i'm afraid. the iphone 4 already feels small in the hand. smaller than the 3gs. dream on i guess.Most of the threads concerning the size of the iPhone involve increasing the size of the screen without drastically changing the size of the device.
I think that Apple should try to reduce the borders around the current 3.5" screen.
Then you would have a nano-sized device without reducing capabilities. The best of both worlds. Devices with 4" screens would be enormous by comparison and would soon look dated, leaving other manufacturers to play catch-up again.
There is undoubtable a market for a cheaper iPhone, if that means making it smaller, who knows?
The thing to consider would be functionality of the touch interface and how that could be integrated in a smaller phone. If that hurdle could be overcome then it's possible? Can't see Apple using buttons...