If this device existed as stated, it would have a smaller ppi than the original iPhone. It appears to me that Apple is done with low pixel density displays.
Rumored Small iPad: 1024*768 @ 7.85 = 163.06 ppi
iPad 1 & 2: 1024*768 @ 9.7 = 131.96 ppi
iPad 3: 2048*1536 @ 9.7 = 263.92 ppi
iPhone: 480x320 @ 3.5 = 164.83 ppi
iPhone 4: 960*640 @ 3.5 = 329.65 ppi
It makes more sense and seems more likely to me to double the iPhone 4's resolution in both directions, thus:
More Likely Small iPad: 1920x1280 @ 7.85 = 293.96 ppi
This would be slightly higher than the iPad 3, but slightly less than the iPhone 4. Right where it should be based on it's size, and viewing distance from your eyes. Plus developers still get the whole benefit of being able to easily remake apps by doubling the pixels on their iPhone 4 app screens.
It's just logical. Can I get some props for that at least?
Well done. I can see this happening if the iPad mini does come to fruition. Doubling iPhone apps would be easy enough. BUT, and iPad mini would be expected to run iPad Apps and downsizing those would be rough (if aiming for the 1920x1280). I expect a 7.85" iPod touch instead capable of using iBooks Textbooks.