Things have changed. Amazon's experience with the Kindle Fire and the Nexus 7 from Google provide market research for Apple. A smaller iPad would be good for for them now.
When news broke last week of a miniature 7.85 inch iPad going to manufacturing, we heard a collective sigh from bloggers: "not this rumor again". If the report had come from a less-reputable source, I would have likely brushed this off as well.
But this time it's different because the market environment is significantly different with the launch of the Asus-built Google Nexus 7. Moreover, the report comes from the Wall Street Journal, which might as well be the official leak outlet for Apple. This leak not only pacifies investors who fear that Apple might cede the rapidly growing miniature tablet market to competitors; it also dampens sales of the Nexus 7 because some customers would wait for an Apple mini tablet.
Doubters predictably will point out that the great Steve Jobs has said that there is no market for a miniature tablet, but they conveniently forget how many times Jobs and Apple quickly changed their minds. Now, it's also silly to expect Apple's Tim Cook to say something to the effect that miniature tablets are wonderful and you should buy our competitor's products while we sit this one out. The reality is that Apple will do what makes sense from a business perspective and they were likely testing and developing a mini tablet even as Apple publicly disparages the form factor.
Up until this point, Apple simply wasn't under pressure to produce a lower margin but higher volume mini tablet. Apple had the luxury of milking its higher margin 9.8-inch tablets while its competitors fielded lackluster products. With RIM asking $500 for a 7" tablet, Apple must have thought RIM's boardroom was on crack (actually, that would explain a lot...). Barnes and Noble did a little better when it fielded a somewhat crippled $250 Android tablet that hardly anyone knew about and Amazon fielded a crippled $199 Android tablet that still managed to push some decent volume based on the strength of the Kindle brand.
Now that Goggle is getting serious and fielded a $199 7-inch full fledged Android tablet that's actually good, Apple can't afford to allow this market to remain unchallenged. As John Gruber pointed out, Apple has learned from its mistakes in the past and they will no longer leave a "price umbrella" for competitors.
The logical course of action for Apple is to sell a mini iPad that is slightly larger but sleeker than the Google Nexus 7, and sell it at a slightly higher price justified by Apple's brand and larger App market. While $299 might leave too much of a "price umbrella" for Google, $249 still leaves Apple with respectable margins. Also, Apple can make even more with expensive accessories and storage upgrades. More importantly, Apple could potentially grow their tablet market several fold by offering a more affordable iPad. NPD has predicted that the tablet market will grow 4-fold in the next 5 years to 400 million units a year and if Apple has its way, most or at least some of those units will carry a fruit logo.
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