I think the form factor would be good for those who don't like the "bulky" iPhone currently, so people just want a smaller phone, but with the same functionality, and I see this phone offering just that. Plus this "might" be able to get us to $99 price points, especially if it comes equiped with 4GB of memory, and have a $199 8GB model, or make it $149. With nice aggressive pricing like that Apple would surely dominate the market with it.
It seems unlikely that Apple would be able to make this device this small with the same level of functionality and hit any meaningful reduction in price point without giving up a lot of gross profit.
This rumor seems like BS to me. I think I would believe Apple would bring back a 4 GB version of the current model or just plain lower prices to gain more market share. I don't see this thing working to expand Apple's phone line without muddying the water. It just doesn't make sense.