Does it use smaller than1/8" Bits

1/8" is the shank size of the bit and the only size that will fit. The actual bit size can obviously be just about anything.

The unit utilizes 1/8" shaft holder and comes with 5 bits. One of the "blade" bits appears to be less than 1/16" wide. The shafts are six sided but the chuck that holds them is only 4 sided? You might be able to adapt other bits to fit if necessary.