Microsoft (NASDAQ: MSFT) is revamping its Surface tablet lineup to include a new 7-inch entry, according to a Wall Street Journal report. The move would position the company to compete in the rapidly growing small-tablet segment with Google’s (NASDAQ: GOOG) Nexus 7, Amazon’s (NASDAQ: AMZN) Kindle Fire HD, Samsung’s Galaxy Tab 2 and Apple’s (NASDAQ: AAPL) iPad Mini.

As the demand for desktops and laptops continues to plummet, a smaller, lower-priced, high-volume tablet potentially could replace lost Windows and application software sales for Microsoft. However, considering the fact that the vendor’s soirees with the Windows RT and Windows Pro tablets haven’t opened too many eyes, there’s no assuming it can make hay with the smaller form factor.

Why will Microsoft add the 7-inch tablet to its mobile device lineup? Industry buzz about a possible 7-inch Surface unit began to heat up when Microsoft dropped the minimum screen resolution for Windows 8 devices to 1024x768 at 32 bits. According to a source in the Journal report, the mini tablet format wasn’t in Microsoft’s plans last year, but top brass worried that the company would too easily cede the segment to others if it didn’t respond with an entry.

Mass production on the 7-inch tablet and other models in Microsoft’s tablet portfolio is expected to kick off later this summer, the report said. At this point, there’s no word whether the smaller tablet will run Windows RT or Windows 8 and where it will be priced. Most of the leading 7-inch tablets are priced around $200, with the exception of the iPad Mini at $300.

Microsoft is also said to be working on designs for a smart watch, possibly joining Apple and Samsung in the race to produce the first wearable, touch-enabled device. Microsoft execs aren’t yet sold on the idea but in the meantime its research and development people are checking out 1.5-inch displays from Asian component makers. No one yet knows if a market for wearable computer will emerge let alone sustain itself but at this point, the early tire kickers want to be ready if the road opens up not only for smart watches but also for devices such as Google’s Glass.