If there is a PAYG option for the iPhone the iPhone will cost nigh on 600 dollars. And an iPod Touch is $299.
You forget that the iPhone is not subsidized at the moment. People are paying the full price, the price won't go up from where it is. The American price is $399 for the base model (8 GB). The equivalent iPod Touch is $299 (8GB). Now if there was a base model 16 GB iPhone for $350 PAYG ($50 less than the current iPod Touch 16 GB)? Most people would I think be happy.