Only if the barriers to entry into that market or product/service stickiness are high. Otherwise, customers, unhappy with the quality, will flee to the competition.
The danger most people worry about is when the customers are getting a better experience at the expense of individuals who don't have any choice in the matter, like in the prison scenario. But negative externalities are hardly specific to this situation.
My point is that market is too good at making things efficient. Its goal is to make things profitable. Which is a decent proxy for the peoples' goal of making a product or service "good", but those two ideas start to diverge at some point.
This is only true if you don't take sticky prices into account. It is quite well established that sticky prices screw with efficient market theory quite a bit, and the scenario provided by the gp sounds like a good candidate for a sticky price scenario.
edit: After thinking about this a little bit, let me go further. The parent's statement is veering into efficient market theory dogma territory. Causality is much more difficult to determine in macroeconomics than in sciences that have the benefit of controlled experiments. There are significant competing theories to efficient market theory that have things to say about scenarios like this, so a straight declaration of cause without caveats is misleading, particularly since efficient market theory clearly does not hold in many observed scenarios. Above, I'm not saying that sticky prices necessarily are the cause of the results that the gp is describing (or even corroborating that the scenario is something that necessarily happens), I'm just showing that the problem probably isn't as clear cut as the parent suggests.