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binary solo said:

a) Natal should be able to detect forward and backward motion of a hand with milimeter precision

b) Also the entire wand has a known shape and size, so there is no need for the lollipop to be a huge knob in order for accurate tracking of the wand in 3D to be achieved.

a)  Try to understand how a TOF camera works to see why this is impossible (for a commercial device, at least).

b) The minimal size of the "lollipop" is given by the space you want to cover and the resolution of the (RGB)camera which ultimately gives the Z resolution you can achieve (XY is obviously less of a problem). You just have to believe that Sony's engineers didn't chose the size for fun and entertainment.