However, most Python programmers tend to just read the
  entire file into one huge string and process it that way.
  I feel funny doing that. Having used machines with very
  limited amounts of RAM, I tend to try to keep my file 
  processing to a single line at a time. However, that 
  method is going the way of the dodo.

  contents = file('filename.txt').read()
  all_input = sys.stdin.read()

This is not the correct way to do things. The first example given is better.

  for line in file('filename.txt'):
    print line

Generators are a beautiful thing [1][2]

[1] http://stackoverflow.com/questions/519633/lazy-method-for-re...

[2] http://www.dabeaz.com/generators/