If his bitcoins are lost forever, does that mean we are going to end up using smaller and smaller fractions of bitcoins in the future as this continues to happen (and it will I am sure)?
That is correct, for a different reason than what you might expect. Deflation from 'losing' Bitcoins is negligible; what really causes deflation over time is increased demand for Bitcoins and not many new Bitcoins being mined.
What is the theoretical smallest fraction bitcoins could handle?
0.00000001 Bitcoins (1/100,000,000 of a Bitcoin) is the smallest unit that it the current system can handle.
Is there anyway to tell how many coins are offline and/or lost compared to how many are floating around in the PtP network?
Not really that I know of. No one knows if you have deleted the wallet file - only that the Bitcoins contained in that wallet have not been spent yet.
