Jesus Christ! You just don't get it do you. It has nothing to do with size. It's about market segmentation. Having a product option that meets everyone's needs. Look through Apple's product catalogue - in just about every respect they have a entry level model, mid range mass market model and an expensive high end model. Again something for everyone. It's basic level marketing / product management.
They don't need to bring out an iPhone Nano coz they already have a cheaper iPhone - the 3GS and 4.
But they don't have a product to satisfy the market segment between the 3.5" iPod and the 10" iPad. An iPad Mini would open a whole new market segment for Apple to sell into.
A 7" iPad Mini only makes sense if Apple moves from the "make your UI look good in these TWO resolution/aspect ratios" to "make your UI look good in ANY resolution/aspect ratio".
There's a very nice simplicity to knowing that my iPad layout is always 1024x768 and my iPhone layout is always 480x320. Points, not pixels.
This is in comparison to what I need to do in Android with layouts which does the latter above.
From a market segmentation perspective the $199 iPod Touch is a mere $200 below a new iPad 2 and only $120 less than a refurb iPad 2 @ $319.
In my mind the primary competitor for the iPod Touch is the PSP, 3DS and Kindle Fire. A 5" iPod Touch would neatly fill the gap between the iPod Touch and iPad without hurting the iPad brand. I'm really hoping that's what all those rumored 4" panels are for and that they are on the high end of 4" (like 4.75")