Talk of a 7.85-inch iPad has been around for quite some time now, but now we're hearing more from John Gruber of Daring Fireball, where he comments in episode #86 of The Talk Show, at 1 hour and 19 minutes into the show. The information of the smaller iPad comes from a question from host Dan Benjamin:

Is Apple going to come out with a 7″ iPad, and if not: why not?

Gruber replies with:

Well, I don't know. What I do know is that they [Apple] have one in the lab…a 7.85 inch iPad that runs at 1024×768…it's just like the regular iPad shrunk down a bit. I've heard from multiple people that this is something that they're kind of noodling with.

Gruber explains that you can get a feel for how a 7.85-inch iPad would feel, by taking a screenshot of a regular iPad in portrait, then turning it into horizontal mode to view the screenshot smaller. This allows you to experience the interface at roughly the same size as a 7.85-inch iPad.