First, I want to say that I agree with Steve Jobs that the 7 inch is too small to have the same user experience as the current iPad.
That being said I am looking at Samsung's claims of selling 1,000,000 Tabs already. In trying to analyze the buy decision of their customers, I have to say it must be based on the portability more than anything else. It can't be a value decision based on the current prices. It hard to think that they feel the performance and usability is better than the iPad unless they are so caught up with their Android phones. So, with the size being that strong of a decision factor wouldn't Apple be smart to just come out a with a IPad mini? They already probably have the design done so it would be just a matter of tooling up. This could also be the low price unit that is sold with less profit allowing Apple to retain their high profit on their " flagship" iPad. The key is they would throw a major wrench into the tablet market with the goal of delaying the competition from building up momentum. With the decent success of the Tab you already have Acer who was ready last year of staying out of the tablet market reverse their decision and plans to come in this coming year. I know it's early and with new tablet coming out the competition will probably canobolize themselves but if this many are sold they can build on that.

How does Apple stop the momentum? Getting a new product in the pipe would take a minimum of 6 months, assuming they have a design already waiting. That gives the already selling, and announced Androids quite a lead time.

A seven inch iPad would harm primary iPad sales more than Android sales.

Doing bargain priced products at lower margins is not in Apples DNA. That would kill their current market plan and drop market prices like a rock.

Jobs would rather kill a product than admit he's wrong. He has proven that many times before.

M [Walt Mossberg]: A lot of people think given the success you've had with portable devices, you should be making a tablet or a PDA.
J [Steve Jobs]: There are no plans to make a tablet. It turns out people want keyboards. When Apple first started out, people couldn't type. We realized: Death would eventually take care of this." "We look at the tablet and we think it’s going to fail."

Interview - 2003

You'll have your 7 inch tablet in seven years.

Nope but a carbon fibre iPad 2 sounds cool.

I think the current iPad screen size in landscape mode is the minimum needed to browse a regulare web site (not a mobile version) and I wouldn't consider a 7inch version.

Nope, no interest at all. I have had small tablets before, nokia, and its not sensible.

If anything I would rather a 11-12" proper wide screen version

All manufacturers of smart phone, are making bigger and bigger screens - for a reason.
I'd like to have iPAD 2 to be lighter and bigger ( 10 " maybe)

7" is neither fish nor fowl, nor good red meat. IMO the iPhone and iPad cover the whole market, so why steal sales with something in between?

I really think they should stick with 10 inch. I'm happy for the android crowd, but I want my user experience to be perfectly polished.

I'm sure Apple tested a variety of sizes before settling for the current one, judging them on a wide range of criteria from portability, battery life, readability, usability and longevity etc..
Also being a software firm they would be also preoccupied with the potential of the device and constraining the size to one where touch control is fiddly would be a limiting factor.
Personally I think they made the right decisions regarding size.

"Jobs would rather kill a product than admit he's wrong. He has proven that many times before."
wow..............you're not paranoid they really are watching you