So the area size of the 3.5" display is 38cm^2, the 7" is about 150cm^2 and the current 9.7" is 289.5cm^2.
So the 7" would have approximately half of its area size. This is way too small to run the same OS. I doubt that they will have another iOS or a new app store.
But I think apple should indeed release a smaller form factor, so they have a wider consumer range.
I personally like 3.5" for example. I'ts about the perfect size for me, but i got a lot of friends that prefer 4.3".
As a phone it's not so bad, but regarding something like a tablet, it's quite important to have the highest consumer range possible depending on such a important hardware feature as the display size.
Hopefully apple is not arrogant enough to be that ignorant, but somehow I doubt that as well.