According to Digitimes,
a smaller 5- to 7-inch version of the iPad is expected to launch as soon as the first quarter of 2011. However, the report says the device will be mostly for reading, and that perhaps would not be a great thing.
For one, the device would sell for below $400, according to the report (which generally means $399), and that's pretty high for an ereader that would compete with the Kindle. Also, the Kindle's e-Ink display is better for outside reading (translation: that mobile market).
Rather than a downsized iPad, we would hope to see an upsized one, instead. At least, remove some of that thick bezel around the edges: that could increase screen size without increasing overall size.
What is interesting, however, is the Q1 2011 timing. The iPhone has, according to Apple, been put on a pretty much annual (meaning June / July) refresh cycle. Could the iPad be getting the same treatment, with a late Q1 refresh cycle? It would make sense.