Agree with you on this.
There are capabilities on the 10 inch model that would not be available on the smaller model. For example the landscape keyboard. It's very usable as is. On a 7 inch iPad it would be more like the current iPad in Portrait mode which is not near as usable for typing.
This is one of the most important reasons why we should not be holding our breath for a 7" iPad.
The following are my objective reasons for rejecting the notion of a 7" iPad.
1. Capabilities due to physical dimensions. The current size of the iPad is what allows the keyboard to be as comfortable as it currently does. This means that doing things such as writing basic texts for emails, documents, presentations, etc. work really well on the current sized iPad. I have played with smaller pieces of paper that might be close to a 7" iPad and I just don't see how it is comfortable to use a keyboard in the similar manner.
As a result, key features on the iPad that work pretty well, such as the Email client, Pages, Keynote, Numbers, and other high-end apps like the Omnigroup stuff are just not going to work as well as on a smaller iPad.
Instead, we would basically be left with scaled-up iPod touch apps instead of scaled down iPad apps.
2. Pricing rubric. At the moment, the pricing for non-contract iOS devices is very linear. From $229 all the way to $829 you have a plethora of devices with different screen sizes, capacities, and 3G ability. $229-$399 is iPod touch. $499-$829 is iPad. There is just not any room for such a device without totally leading to confusion.
3. If we consider point 1 and point 2, we get to the main concern which is confusion in the line. At the moment if you go into an Apple store seeking a non-phone iOS device, the choice is clear. If you want something that fits in your pocket, plays movies, games, has a decent browser and email client, and is with you all the time, there is the iPod touch. It will set you back $229-$399. If you want something that offers demonstrably better productivity and more real estate that allows better typing, iWork apps, and a better reading experience, there is the iPad. It sets you back $499-$699, plus an additional $130 if you want 3G capability.
A 7" will totally confuse a customer, which is something Apple does not want to do. They will cede a size or class of device to another company if it blurs their own line. It will be bigger and more expensive than an iPod touch, and will probably provide a better reading and video experience. It will be smaller and maybe cheaper than the iPad, but won't be as capable in terms of apps and the keyboard.
The valid arguments that I have heard in favor of a 7" iPad are as follows:
1. Size and weight. A smaller iPad would be lighter and be more portable than a 10" iPad. The weight thing I totally understand. I would like to have the iPad be lighter than it is at the moment. Size though, if it can't fit in a pocket, you still need a bag, and I doubt Apple would really go in that direction just to make a size in between the two. On weight, I imagine Apple would work on making the current iPad lighter rather than making it necessarily smaller.
2. Competition with the Kindle and the forever in waiting 7" Android OEM tablets. The kindle is not a direct competitor to the iPad and it never will be. It is just an unconvincing argument that Apple wants to kill the Kindle. If the rumors are true that Apple is done with a 7" tablet, then it is not in anyway a response to competition. It would have been something in the works for much longer, and would be a device that seemingly breaks away from the mode of clean product lines.
3. "Retina" style displays. A 7" iPad would automatically have the same resolution as the 10" iPad and would result in sharper text, pictures, etc. The argument also seems that since it has the same res, all the apps that I had previously mentioned would still be able to work. Again, I just don't see it. Take a Keynote file that you are editing on the current iPad, and open the keyboard so you can edit a slide. Try moving that to a noticeably smaller display and think if that's usable?
I just think that if you list up the arguments for the existence of a 7" iPad and the arguments against the existence of a 7" iPad and there is a lot to overcome.