One reason often given that Apple wouldn’t make a smaller (cheaper) iPad, is that apps would have to be re-designed to fit a third screen size. The iPhone has always been 3.5″ and the iPad has always been 9.7″, giving developers 2 screen sizes to support, if they want to have their app on all iOS devices. Adding a third size to the mix would have to gain consumers and Apple a lot, to be worth the increased fragmentation in the App store. The problem is that, as buttons shrink, they get difficult to press, given our fat fingers. (This isn’t a big deal on computers, because the point on a mouse is always 1 pixel.)
However, it looks like Apple have built in a redundancy that would allow existing iPad apps to shrink to 7.85″ and still be usable.
The original iPhone screen was 163 PPI, and Apple’s design guidelines state 44px by 44px is the smallest comfortable size for a button (or any tappable area) at that pixel density. The design guidelines for the iPad uses the same minimum pixel-size, despite it’s screen having a lower density. The result is that the smallest allowed button on an iPad is physically bigger than on an iPhone. Shrinking the iPad to 7.85″ and giving it the original iPad’s resolution (1024 x 768) gets to the 163 PPI of the original iPhone. It would run iPad apps simply shruken to fit the screen, and despite everything being smaller, buttons are still big enough to comfortably use.