For some, the ipod touch is simply too small to be productive. My own eyes at my tender age of 48 don't handle the iphone/touch size very well. On the iphone, it does the job because I'm not going to start creating a whole lot of documents, the same can be said of the touch, but the ipad is a different beast, it's primary purpose really is to consume/create.
Botton line though, there is obviously a market for a smaller iPad, sales of the other smaller devices proves there is a market need for these (price is not the only reason why!). Maybe not for you, or for me but for a lot of other people. Although you still can't fit it in your pocket, it probably fits in a lot of purses out there

and with the smaller screen, maybe it can be priced $100 less and fit that market.
BTW, can someone explain the logic behind how it's determined a smaller ipad would fragment the market? If it uses the same CPU/GPU, the same ram and the same resolution, the only thing probably affected is battery life and the only difference aside from size of the device is the pixel size which are smaller. The screen real-estate if it's an 8" device would be no different,just items are a bit smaller. 8" is not that big a difference from the standard ipad that it needs to have its own resolution. Ipad 1/2 and ipad mini should have zero development incompatibilities.
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No, it would not. The finger touch area would be too small - in fact it would violate Apple's User Interface Guidelines.
Though it may be true, I've not heard of this before. Selecting icons,etc on my iphone requires me to make minor adjustments, for example, the onscreen keyboard's keys are much smaller on the iphone than the ipad. I would think an 8" ipad would not be that different, though I acknowledge I may be totally off base in my own "mind's eye" view of how the interface would still be workable.