My theory on the iPod touch is that it's a scheme to further cement in people's minds the association between the iPod and the iPhone. I don't think they ever expected it to be a cash cow. If they did they probably would have killed off the classic iPod. After all, Apple consistently makes products that consumers aren't necessarily clamoring for and then tells us it's exactly what we want. The iPod Touch is kind of an oddball in the iPod line and they treat it like one.
You've got the classic iPod with scroll wheel and hard drive. You've got the smaller one with scroll wheel and flash memory to compete in that market. Then there's this touch screen thing that's basically an iPhone without the phone and it's called an iPod. The capacity is low. The battery life is abysmal. It's just as big and expensive as the iPod classic. I don't have a clue what's compelling about that. But people see the iPhone and think "it's just like the new iPod only it's a phone too."