Yes it is very bad. Game developers are companies. Companies need to make profit. If a market segment shrinks, the shareholders force a company to leave the shrinking segment. Developers that leave the business and move to Iphone / Android / PC Free to Play are lost and cannot create console games.

A shrinking market means Wii-U style 3rd party support for PS4 and X1. Less or no 3rd party games means death.

Well, this is a Gamer Centric view. And growth isn't always good, these ballooning budget size an mass appeal low substances games are akin to tumors.

A healthy market is a lot better than a bloated one, and refocusing I thinking will make the market more healthy.

YES
It is shrinking since 7th gen because PC's and tablets/phones

Less potential customers is always a bad thing.

A growing market would be of course the ideal but I don't think its shrinking will have too many negative effects.
What it does I hope is developers and publishers being more effective with their resources.

Your mistake is thinking that developers are trying to appeal as many people because the market has grown when actually, most devs love that big market because that means that there will always be someone who will like their game. Your Dark Souls example fits this perfectly.

But the truth is that publishers (not devs) try to appeal to as many consumers as possible because game development and specially marketing has become a lot more expensive. And it's because of that, that if the market shrinks publishers will force devs to make games that appeal to the vast majority of consumers, not the other way around.

Big market => room for everybody # small(er) market => someone will have to leave

Diversity is suffering because of the cost of game-making. Not because of the market size. Sorry to say it, but your OP made zero sense.

No necessarily.

Market will adjust, crap developers will die the best will easily survive. New ones will take their place.

Cost of game making is increasing because of increased market size.

The gaming industry relies on unrealistic growth levels as it is. So yes, market shrinkage will be a problem.