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The two iCloud Photos storage settings options in iOS > Settings > Photos are:

Optimize iPhone Storage

If your iPhone is low on space, full-resolution photos and videos are automatically replaced with smaller, device-sized version. Full-resolution versions can be downloaded from iCloud anytime.

Download and Keep Originals

This iPhone is currently storing original photos and videos. Turn on Optimize Storage to save device space and keep originals in iCloud.

The behavior I want for my iOS device is to save as many photos on-device as possible, but then to fall back to iCloud thumbnails + download on demand functionality when the device is getting close to full.

Is that what "Download and Keep Originals" does? Or does it fill the iPhone's device space? Does it prevent you from taking new photos if your iCloud library size is bigger than your phone storage size?

I have more than 1TB of iCloud photos, so the library will not fit on any iPhone sold by Apple. What is the behavior of "Download and Keep Originals" if the iCloud photo library is bigger than the iPhone device storage?

Does buying a 512GB or 1TB iPhone increase the cache that Photos uses when "Optimize iPhone Storage" is on? Or will Photos continue to only use a relatively small cache (~30GB) and "waste" the extra local storage space?

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Is that what "Download and Keep Originals" does? Or does it fill the iPhone's device space? Does it prevent you from taking new photos if your iCloud library size is bigger than your phone storage size?

Download and Keep Originals takes all the original quality photos from iCloud and replaces the lower quality images on your iOS device. This is the opposite of what Optimize iPhone Storage does. Since it uses up your device's storage, you will not be able to take additional photos, install apps, etc.

I have more than 1TB of iCloud photos, so the library will not fit on any iPhone sold by Apple. What is the behavior of "Download and Keep Originals" if the iCloud photo library is bigger than the iPhone device storage?

Once it runs out of space, it will not replace remaining low-quality images with original quality images. You also won't have additional space to take new photos, download and install apps, etc.

Does buying a 512GB or 1TB iPhone increase the cache that Photos uses when "Optimize iPhone Storage" is on? Or will Photos continue to only use a relatively small cache (~30GB) and "waste" the extra local storage space?

Buying a larger sized iPhone storage allows you to store more lower, or original quality images, depending on your setting. It does not improve the lower resolution images to somewhat better resolution.

From https://support.apple.com/en-us/HT201656#recommendations

About cached files in "Other"

The Finder and iTunes categorize cached music, videos, and photos as Other instead of actual songs, videos, or photos. Cached files are created when you stream or view content like music, videos, and photos. When you stream music or video, that content is stored as cached files on your device so you can quickly access it again.

Your device automatically removes cached files and temporary files when your device needs more space.

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