Apple was just reassuring customers and the market, by telling them that their tiny size and newbie market status was an advantage, not a disadvantage.

But they clearly had high ambitions for their new revolutionary ergonomic mobile "phone" + "music player" + "internet". They wanted to define a new indispensable market and they wanted to own it. They already had a multi-year product path and design pipeline for regular major upgrades in place.

The iPhone was intended to be a "next big thing" from the start.

And it seems unlikely Steve was selling Intel on doing a new chip for 1% of the phone market. He was telling Intel this was the future, in some form.

Apple was an objective market demonstration, with no ambiguity, that there was now a need for low-power first (as apposed to speed first) that would got to other suppliers if Intel didn't move.

This was a leadership failure at Intel. They happen.

I always thought it was a response to other cell-phone makers integrating music-player functionality into their cell phones, threatening Apple's music-player revenue stream.

Me too. Ballmer's reaction to the iphone was not obviously stupid at the time, especially given Microsft's business model of direct enterprise sales.