JOIN USApple also is developing technology that makes it easier to use the iPhone on multiple wireless networks, The Age reported.Chief executive officer Steve Jobs, who remains involved in strategic decisions while on medical leave, aims to narrow the price gap that has made phones running Android more popular than iPhones.
Google's share of the global smartphone market more than tripled to 32.9 percent in the fourth quarter, eclipsing Apple's 16 percent, according to Canalys.
Apple has considered selling the new iPhone for about $200 in the US, without obligating users to sign a two-year service contract, said the person who has seen it.
Android phones sell for a range of prices at AT&T, Verizon Wireless and other US carriers, and typically come with agreements that include a fee for broken contracts. The iPhone 4, sold in the US by AT&T and Verizon Wireless, costs $200 to $300 with a contract.
Natalie Kerris, a spokeswoman for Apple, declined to comment.
The prototype was about one-third smaller than the iPhone 4, said the person, who saw it last year.
Apple can sell it at a low price mainly because the smartphone will use a processor, display and other components similar to those used in the current model, rather than pricier, more advanced parts that will be in the next iPhone. Component prices typically drop over time.
Apple is also working on a so-called dual-mode phone. This device would be able to work with the world's two main wireless standards - the global system for mobile communications, used by AT&T and carriers such as Vodafone, and code division multiple access, used by Verizon Wireless.
Apple is working on a technology called a Universal SIM, which would let iPhone users toggle between GSM networks without having to switch the so-called SIM cards that associate a phone with a network, according to one person.
This would help cut the cost of distributing and managing millions of SIM cards.
The new features could also give Apple an advantage over mobile carriers in influencing customers. The device would be affordable without a carrier subsidy, so buyers wouldn't need to agree to terms, such as termination fees, that carriers demand in exchange for subsidising the cost of the phone.
Apple has also worked on redesigned iPhone software that would let customers choose a network and configure their device on their own, without relying on a store clerk or representative of a carrier, the newspaper said.