While phones were routinely 'free' or $99, iPods were wildly popular in 2007 and routinely cost $300+, and one of the three legs the iPhone stood on was being an iPod.
It should have been a red flag back then if market researchers and the people that hired them didn't see this as a convergence of music player + phone markets; it was the point of the keynote! I remember people complaining then that they had to carry both their phone and their iPod around back then.
The smartphone market was also growing then, and devices like Blackberries and Treos were popular and cost $200+ on contract. I had been using a Treo since 2005, and remember the pain of getting apps on it and getting it to play mp3s or use GPS maps. When I saw the keynote, it was clear it was just the next logical step.
It's weird that Windows Mobile didn't see these trends. Perhaps it was a case of underestimating the general market interest, though iPod's success should have been a strong hint that consumers really wanted devices of this type and were willing to pay. iPods were more popular than Windows Mobile devices even then.
Finally there's just the 'sit down and use it' factor that the iPhone had. Once you played with it, it was hard to deny that it was the future. The fluidness and straightforwardness of the UI was so far ahead of everything at the time. Best I can think of as a comparison is sitting in a Tesla Model S after getting out of your Honda - it's not a question of if, but how much.
At $599 the iPhone was definitely expensive for the time, but any reasonable businessperson could conclude from watching literally the entire history of technology that component prices are always on a steady decline, and there were other levers to lower price like carrier contracts. When the iPhone went down to $399 a few months later it's success was a foregone conclusion - after all, that was just a bit more than an iPod but with way more capability.