Capacity is shrinking and my own personal experience is that prices are increasing.
That capacity is shrinking is possibly true; and yes prices are probably very slowly creeping up. However pricing on short-haul flights is, for the most part, unsustainably low, and has been since EZY/FR and the gang moved in.
I'm slightly too young to remember what you would have paid a for a return LON-Scotland flight 20 years ago... £100? About the same as today, if not more. Given inflation, fuel costs, taxes/fees I'd say its a pretty good deal.
Its this pricing that has sadly ground airlines like BMIr into the ground. EZY/FR rely on the 'pile em high, sell em cheap' ethos and low overheads, BA rely on longhaul connections and business pax. BE sit rather uncomfortably in the middle... Hence they have been pushed out of the market.