People familiar with the matter and close to Apple's suppliers have hinted the existence of a smaller iPad, with a screen size of around eight-inches. The rumored screen resolution will be somewhere around the 1024x768 currently on the iPad 2, which will bump the pixel resolution from 132 at the moment to 160 on the smaller tablet. Of course the iPad 3 is said to bring "Retina" display to the tablet enthusiasts.
The existence of such a device doesn't necessarily mean it will ever see the light of day. While Apple could decide to never release a smaller tablet, it would be normal to address all the screen sizes in the Android-tablet competition line-up, where manufacturers like Samsung released tablets with screen sizes ranging from seven inches to 10.1 (and even a 11.6 rumored to be in the works).
Source: The Wall Street Journal