Two things I have to say to this:
1. Many larger Japanese companies have completely mismanaged their franchises this generation; either making them more "westernized" in an attempt to get more exposure in the west (i.e. Final Fantasy; Resident Evil) or just simply ran out of ideas/a wall in the genre but continued getting made (i.e. Tekken; Devil May Cry). Rather ironically, it happened at a time when many of them actually went multi-platform with Xbox after years of PlayStation exclusivity. So I think to say "Why do they ditch Xbox if they need to make money and exposure in the West?" is pretty short sighted, when many of the bigger devs did the opposite and managed to completely balls it up, with a few exceptions.
2. Smaller Japanese devs know how to manage their budgets, and there is nothing wrong with that. Targeting a game for their home country will see bigger returns. Take my oft-quoted example, Compile Heart. They seem to need to sell ~ 45k copies to be profitable. The easiest way for them to do that is simply target a niche audience in Japan, and sell to them. Those niche audiences tend to flock to certain consoles, and this generation it's been the PS3 (which is the same reason why Falcom; Nippon Ichi; Gust etc. all develop there too).
If they want to sell a game abroad, they'll have to licence it to an overseas publisher, as they're nowhere near big enough as companies to be able to localize & distribute a game overseas (nor do they tend to have the local knowledge of how to go about that). This means that the aim shouldn't be to make a title to appeal to the west; as it's simply hit or miss whether any western-capable publisher will show any interest (and they'll receive less money for licencing the game than they would for publishing it themselves).
So you've got a divide between the bigger Japanese devs/publishers who are trying to make inroads in the west yet failing to understand the basics of what made their games sell in the first place; and the smaller devs who stick to an audience they know and understand and if they can go further than that - a bonus. If not - they won't go out of business.
(Besides, I always find it absurd that it's possible to criticize small Japanese devs. After the generation we've had in the west of company after company shutting their doors for making too ambitious projects which bombed; we should be looking to Japanese teams who are still chugging along to see what they're doing differently. The answer? Identify your market and sell the game to them and KEEP_WITHIN_A_BUDGET).
There was a third point I wanted to make, but I've forgotten it. May reply again later.
edit: Just remembered it. Nothing too important though:
3. As Salnax says, Japanese gaming habits have shifted to handhelds/phones; and that's why we're seeing a much, much smaller output on home consoles.
