Indeed, regulation is the only way to protect passengers from market greed here, but the airplane makers play a critical role in what designs they make available to airlines. Airbus and Boeing both like to market their newer designs and interiors in terms of passenger comfort (lower cabin altitude, reduced noise, larger windows, etc) so clearly they (and their customers) understand that passenger comfort justifies spending somewhat more than the bare minimum. And given past designs (and designs still fitted in widebodies) they very much know how to build useful lavatories.

I suspect in time there will actually be safety consequences to the continued downsizing of airplane lavatories. There are already a number of serious incidents that have been caused by fluid leaks from galleys and lavatories (IIRC Quantas came pretty close to losing a 747-400 due to a kitchen leak leading to massive water intrusion into the main electrical/avionics bay - once you end up pouring large quantities of water on your avionics all bets are off about the systems failures that will happen and you are well beyond any backup/redundancy that has been designed in, and during the 60s and 70s the USAF experienced serious corrosion of flight control cables on C-130s due to urine "leakage"). Too-small lavatories basically guarantee that water and urine are going to end up in undesirable locations and at best they will cause expensive interior corrosion and at worst they will cause serious corrosion to the airframe or critical equipment.