Sources close to the company claim that it would be rather difficult to create a smaller iPhone, as the entire platform is based on one form factor and one screen size. A smaller device would be harder to operate and many developers would have to rewrite their apps to better suit the new format.
Steve jobs recently noted that one of Apple’s key advantages over Android based products is uniformity. He believes the Android platform is becoming too fragmented and thus less competitive. There are already dozens of Android phones with different screen resolutions and hardware, making life a bit more difficult for developers.
There’s also the issue of software updates. While Apple can concentrate on single, prolific phone series, many other vendors have to prepare software updates for a variety of phones with an entirely different spec sheet. This makes it less likely that obsolete handsets or those sold in small numbers will get regular OS updates, as they are simply not worth the bother.
On the upside, Apple is apparently looking into internal tweaks and redesigns aimed at reducing production costs. So, we might see cheaper iPhones, but the form factor will remain the same. Opting for less memory, a cheaper camera or somewhat slower processor could bring the price down, while still sticking to the same basic platform and form factor.
More here.