I for the most part agree with the first 3 paragraphs in your post, so I’ll jump right into the 4th, which is where I start finding issues.
“ The reason that government regulation is needed is due to the logical outcome of any owner of a firm under capitalism; minimise expenditure and maximise sales for maximum profit.”
The sales maximising level of output is not the same as the profit maximising level. The firm [owner] under capitalism would theoretically always choose the profit maximising level, where marginal cost and marginal revenue are equal.
“ …businesses can afford to alienate customers because they know more are readily available and not so demanding. It becomes a downward race to the bottom, as firms can lower their standards further and further over time because nothing is stopping them doing so.”
A race to the bottom will not occur in this scenario, even considering the large sunk costs that would act as a barrier to entry. This is because each [large] firm knows that, if they offer close substitutes, a small price decrease (let’s assume to be achieved through lowering standards) will win them a large chunk of their competitors’ consumers. This small price decrease would cause a fall in total revenue, as the demand is price-inelastic, but their new customers compensate for this. The problem is that all competitors will follow suit, most likely undercutting the new price. The consumers move yet again, and this would continue with a “race to the bottom”. At this point, the consumers in the market would be spread between the firms, as they were to begin with. At this new super-low price, each firm’s total revenue would be drastically reduced. Firm owners know this, and so there will be tacit collusion between firms, i.e. agreeing (without saying so) to not undercut each others’ prices. This can be observed with large supermarket chains, which are not constantly undercutting each other, even though there are not many regulations in place to stop them from doing so in the UK.
In addition, behavioural economic theory challenges the assumption that consumers base their buying habits solely on price, which leads to the (likely) possibility of a [water supplier] using advertising to show consumers that their competitors are cutting corners, whereas they take quality seriously. This makes cutting corners risky from a business standpoint as well as a legal one (a class-action settlement about water poisoning can be pursued through an arbitration agency very easily, even without a government court). Free-market independent quality monitoring agencies (which would make offending companies known to the public) would also arise in the event of large-scale negligence in a sector such as water supply. Something of that scale is a matter of great public interest, and hence would be voluntarily funded by the affected population or philanthropists. The primary factor that would prevent extreme cost-cutting measures in such a market would be that there simply isn’t a profit incentive, because doing so creates a huge profit incentive for any of the firms to become the “one decent water supplier”.
As your final paragraph works on the assumptions which I believe I have found flaws in, I won’t try to pick it apart any more than I already have. I would be interested to know, however, which alternative economic systems do you think show promise, with regards to ethical and economic consistency and sustainability?