In my experience if you are thinking about reducing the price of product or shipping and have to choose, go with shipping. It's single handily the biggest barrier to checking out with sites that charge for it. Even if you can't offer free shipping because of margins you can always subsidize it.
SocialSkateboarding.com increased their sales conversion 60% by reducing their shipping charges to flat rate $6.99. Where as before they were just getting realtime rates from FedEx and the standard rate would usually be around $9-10.