I wonder whether people actually understand that they need a smaller engine for the same performance?

Despite my overall low estimation of people's ability to fluidly reason about engineering tradeoffs, I think they generally do understand this one well enough, at least for the decisions that they will face. They're only deciding which car to buy, not what engine specifications are required to make a car successful in the market.

They go test-drive cars, probably glance at performance specifications and/or read/watch a test drive review of the cars. They can look at the 0-60mph/0-100 kph times and get a feel for "this car will be able to get out of its own way" vs "this car will be a rolling roadblock".

So "actually understand"? Maybe not, but "understand enough to guide their purchasing decision?" and therefore enough for the actual automobile product teams to design to accommodate? I think they do.