He's talking about cost of actually building the device. A big part of the iPhone's consumer price ($700 for 32gig) is markup, as he points out in comparing it to the price of the iPod touch, which is $300 for a comprable model.
In other words, he's claiming that Apple could undercut the A8181 Desire or the Galaxy S on price, but keeping the customer choose between "FREE* shiny new phone" or "$200* shiny new phone" reinforces the perception of Apple as a premium brand.
* with 2 year contract