We have a slightly different method: A text field. This allows the user to tell us as much or as little information (to the suburb/city/country) that they live in. Sometimes, users want to be more specific.
I can see both sides viewpoints on this. Adding country flags to user profiles sounds like a good idea. It would look really nice to see them displayed on user profiles. Then again, the "Location" text field is more than enough for user profiles. I would not mind either way though. It is no big deal to me.