A cheaper, smaller iPhone may be on the way.

The Wall Street Journal reports that Apple (Nasdaq: AAPL) is developing an entry-level version of its trendsetting smartphone. Unnamed sources have seen prototypes of a new iPhone that is half the size -- and roughly half the cost -- of the current iPhone 4.

I'm scratching my head over the functionality of a device that's half the size of Apple's popular gadget. Maybe it's just me and my pudgy fingers, but sometimes, even the original iPhone seems a bit too compact.

However, the possibility that Apple might crank out a new line of iOS smartphones at lower price points is huge.

Apple sells its iPhones to AT&T (NYSE: T) -- and as of last week, Verizon (NYSE: VZ) -- for an average of $625 apiece. The wireless carriers then subsidize hundreds of dollars to get the iPhone 4's price down to $199 for the 16GB model and $299 for twice that storage capacity. AT&T and Verizon can take the hit, because they know that they'll more than make it back during the life of the phones' two-year contracts. Buyers who want an iPhone off the contract need to shell out $599 and $699, respectively.

If AT&T and Verizon can shave $400 off a $599 iPhone, what can they do with a half-priced $299 iPhone Lite? For starters, they can offer it for free, tied to a 24-month contract. Perhaps more importantly, that kind of price point would also open up the realm of iOS smartphones to smaller carriers and emerging markets, which typically charge less for their monthly plans.

Battling the droids
If the reports are accurate, Apple may simply aim to compete against the growing appeal of Google's (Nasdaq: GOOG) Android operating system. The open-source nature of Android has opened the floodgates for handset manufacturers to crank out spiffy smartphones at cheaper price points than proprietary platforms.

Too much of the global market simply can't afford the costly iPhone and its hefty wireless plans. Sales tracker IDC pegs Apple's share of the global smartphone market this past quarter at a reasonable 16.1%. However, Apple's slice of the world's entire handset market checks in at a more modest 4%.

In short, Apple can't afford to price itself out of the market. As owners of old-school feature phones around the world make the smartphone migration, they'll likely gravitate to the cheapest of the web-savvy handsets.

Beyond the Android invasion
We're not just talking about Android anymore. Nokia's (NYSE: NOK) decision to accept a ton of Microsoft's (Nasdaq: MSFT) money -- billions, according to CEO Stephen Elop -- should make Windows Phone 7 a force to reckon with.

Nokia is the Earth's leading handset maker. It's been fading in recent years, but still sold nearly a third of the world's cell phones this past quarter.

Can Apple afford to ignore the low end of the market? It's not growing as quickly as Android these days. Reports of Research In Motion's (Nasdaq: RIMM) death have also been greatly exaggerated, as it continues to tack on BlackBerry users.

If Apple finds itself competing against BlackBerry and higher-end Android devices for the upper crust, it will miss out on the real action taking place in the pie's bubbly filling.

Apple has an opportunity here. It can be satisfied with a thin global slice in the premium category (as it has with computers) or it can try to own the market at all price points (as it has with the iPod).

The risks of playing small ball
Even if Apple hits the market with low-end iOS smartphones that can cash in on its App Store ecosystem, it shouldn't count on a slam dunk.

Smaller models risk cannibalizing their big sibling's sales, should they prove as competent and feature-packed as the regular-sized iPhone. By the same token, if Apple strips away too many of the features of its flagship iPhone, will it still be able to compete against Android and the Nokia-fortified Microsoft?

Despite these potential problems, the appeal of a device that will let Apple push into lower price points cheaper wireless carriers is too juicy to ignore. The company has come too far to settle for too little. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.