Except that a 32GB iPhone without a contract costs $700, and a 64GB iPod Touch costs $399. Some of us will NEVER buy an iPhone as long as AT&T has exclusivity rights.
Yes the total cost is overlooked by many people.Lots of people get a touch and a go phone or other cheap "dumb"phone to save a lot of money.Many others live where they can't get a good signal from ATT,or ATT at all.Then there are people who just don't like ATT for whatever reason.I'm sure they wouldn't mind if the touch had a camera.
And then there's the unanswered question:What would be so bad if the touch DID take a few sales from the phone?After all,they are both Apple high margin products.
The only loser I see in that situation is ATT.
But I don't accept the premise that the two products compete to any great extent anyway.