The new model is described as being one-third smaller than current models but Bloomberg notes that its introduction to market isn't yet a certainty, as the company often works on products that eventually get scrapped. Meanwhile, a similar report on the Wall Street Journal suggests Apple may cut or ditch internal storage entirely and rely exclusively on a revamped, free MobileMe service that would serve as a cloud-based 'locker' for apps, photos, music and videos.
Doing away with internal flash storage would certainly help with the cost but it also ignores the reality of wireless networks -- limited coverage, poor signal in many areas, and carriers' restrictions on bandwidth. Even though Wi-Fi might mitigate some of these issues it would still be too impractical for iPhone users. It's not out of character for Apple to take a popular yet pricey product and make smaller versions that are more accessible to price-conscious customers -- the iPod is a prime example of that -- but we still have our reservations about this rumor.
Another more recent leak, courtesy of DigiTimes, says that the fifth-generation smartphone will actually feature a larger 4-inch display to take on Android devices such as the Galaxy S 2 and the HTC Desire HD. Again, you should take all this with a grain of salt, even more so when you consider the timing of the rumors (during MWC), let alone the fact that having multiple devices with different screen sizes would make life harder for developers powering the iOS platform.