NZtechfreak: I can't really see Apple producing a cheaper iPhone, that isn't really in their DNA and doesn't fit with their brand image. I think they'll just make the older iPhones the second tier, much like they have done with the iPad2.
They did with the ipad mini though, but that was solely a defensive move IMO. Even though it has ended up being a preferred device by many over the ipad. They already do produce a cheaper iphone in a way, as they retain the old models at a cheaper price. But I can see a market for a smaller form factor iphone and a larger form factor one.