But we get rid of those people. Which I understood from last generation is a desirable thing.

*sarcasm detected*

LOL

You are going to need to back up your point that diversity is shrinking due to increased market size. Theoretically, diversity would increase due to a better ability sustain niche markets....

Additionally, Dark Souls sold about 2.8 million compared to Demon Souls' 1.7 million due to an increased market size. I don't understand what you are trying to argue there.

Once again, we agree about the problems in the gaming industry, but we disagree on the reasons why. I believe that it is mostly due to development philosophies (everybody wants the biggest slice of cake so they ignore everything else), and you seem to believe that for some reason, a bigger market share makes companies make less diverse games...

@A few other people: Eliminating games like Carnival Games wouldn't necessarily benefit gamers. Look at the list of titles WayForward has made for some evidence on that point...

This is where I got confuse on you OP (and it seems a few others). What you mean by "mass appeal" is not the same as appealing to an untapped population to expand the market. I think what you are saying about "mass appeal and growing market size causing stagnation" has little to do with the exapansion of the gamers population. 

They are not increasing budget on these AAA games to expand the videogame market, but to expand thier userbase/fanbase. They are doing it to tap into an already existing market. For example GTA, does little to expand the market. It taps into those who played the prevous GTA games, CoD/BF gamers, Sports/Madden/FIFA, etc. but not the smart device gamers and those who had little interest in games.

With a shrinking market, audience diversity either stagnates or decreases. I think there are two main answers to a shinking market in-order for companies to stay afloat. The first is to do the same tried and proven approach. The second is to take risk to expand the market. Unfortunately, tried and proven is what most will do. This mean developers will focus their money on what they know will work, rather than taking large risk on unique games. So, yes, a shrinking market is usually bad.

I think that the market shrinking in terms of number of gamers is good for traditional console gaming and PC gaming. Someone said that with a bigger market you would think there would be more diversity. That isn't necessarily the case. That is because as the market grows publishers chase what will sell the most and streamline their games more and more and take fewer risks. I think with the possibility of the market shrinking, gaming can return to its roots and be more true to itself and move on from there.

It wont make much of a difference in software sales. At least half of the people that buy consoles are casuals that only buy 2 or 3 games all generation. And that goes for Sony and Microsoft too. Not just Nintendo. Casual gamers are all caught up in the mobile boom right now. Hardware will be significantly smaller this gen, but software will stay fairly close to where it was.

You're just imagining the worst cases.

Lets say, for sake of example, we went from 260mill last gen to 200 mill this gen with PS4 80-100, XB1 50-70, and Wii U 30-50.

Last Gen: 260 million

 (despite most marketshare)

29.49 million LTD an attach rate of about 11%

On a smaller market of 200, COD has less consumers to tailer for and can make the game itself better.

For a market of 200 million, all it would need was a 22% attach rate to meet the sales of a market 30% bigger than it.

This is what I'm trying to suggest, focusing a larger less focused based at the cost of a smaller more dedicated base. At its extreme, this is like mobile vs console i.e 60 million users for 1$ game and 1 million users for a 60$ game. For sake of argument lets say the cost is completly indicative of the budget and the budget is completely representative of the quality. They both make the exact same amount of money theoretically, but it will be much harder for a 1$ game to have 60 million users than a 60$ game to have 1 million users

We can also look at it this way:

Imagine Gen 7 ending in 2015 at a totaL of 280 million, up from 200 million in Gen 6. That is an average growth of 4% per year over Gen 6 (not entirely accurate since generations cross each other somewhat, but it gives a hint). That isn´t a huge growth, but actually quite reasonable.

If the market would start to experience contraction, money will start to pour out of the industry causing more studios to stop making games for the traditional consoles. This will also start a downward spiral in the general publics view of the industry, causing even bigger declines in sales.

I Think an average growth of 2% per year over previous generations should be acceptable enough to maintain a steady industry.

If you think this is has an easy answer, then you clearly are overlooking some things. This is an extremely difficult question.