According to an article over at the New York Times, the rumors about a smaller iPhone may not be quite right:
Apple’s engineers are currently focused on finishing the next version of the iPhone, which is likely to be similar in size to the current iPhone 4, said one of the people. The person said Apple was not planning to introduce a smaller iPhone any time soon. Analysts expect the new iPhone to be ready this summer.
Another person who is in direct contact with Apple also said that the company would not make a smaller iPhone at this time, in part because a smaller device would not necessarily be much cheaper to manufacture and because it would be more difficult to operate.
Coupled with the rumors about a larger iPhone on the horizons as well, the only thing that is clear at this point is that there is a new iPhone on the way.
My gut says that the iPhone 5 will sport the same 3.5-inch screen that every model of iPhone has sported so far. Unless Apple can get different sized displays to show the same number of pixels at the same density that the iPhone currently shows, physical changes may create nightmares for developers. With the Retina Display, Apple was able to gracefully move developers to the higher pixel density. I don’t think the company is going to do anything to jeopardize that.