The most important question involved with increasing the screen size is what the story for developers is. Increasing the screen size from 3.5" to 4+ inches would cause many many apps to be rewritten. Yes, you could just scale apps up and they would work a lot better than they do scaled up on the iPad, but even scaling them a little would change the physical size of buttons and text etc. that were all designed to be a different physical size. That means definitely doing new artwork for this third physical size, but in some cases, it probably means doing a slightly different design! With a bigger screen, maybe you could squeeze an extra button on your toolbar. That means that an app developer has to manage three different versions of their app (iPhone, iPhone+, iPad) with two of them being very similar. That adds complexity and the possibility for bugs.

Why would Apple want to impose that extra workload on itself and its developers?