I think it is pretty safe to say that game publishers prefer to invest in the development of a quality experience when the market allows for it but similarily have to watch costs and hedge bets when it doesn't. I don't have access to the production budgets of games outside my own company but I would guess that last year's top PS2 titles had, on average, the highest development budgets of the console's life cycle. Potential for sales grows with the console install base. When you know you can potentially reach so many it is easier to make the business case to invest the extra million or two for polish and help distinguish your title from the competition. Some might say the business case demands it.
In these transition years to "Next-Gen" the publishers are faced with two unfortunate realities. First, sales of current-gen games dropped off far quicker then many anticipated, and second the widespread adoption of next-gen hardware (for the sake of this post, 360 and ps3) has been delayed by multiple factors. Shipping only on the 360 & PS3 within the next 6-8 months creates a challenging financial reality for publishers. If they aren't particularily careful with development budgets there will simply not be enough consoles on the market to reach the critical mass needed to break even. Three games for the 36o have so far sold more then a million copies. The rest were probably either: (1) cheap to develop (due to existing assets or code from a previous installment in the franchise) (2) waiting for the PS3 to hit the market so a 'cheap' port can help improve the ROI or (3) not profitable.
My guess is it could be a couple of years before there are enough NG consoles on the market that games other then the absolute top sellers (or sequels) are comfortably profitable. In the meantime I think you'll see some publishers being extra careful.
Now, as I said when I started -- there are huge generalizations here. Publishers will create loss leaders to establish brands, they'll recoup the significant R&D costs on the 1st generation of NG titles when the sequels hit, etc. Additionally I'm not implying that the quality of the first-gen-next-gen games is necessarily low -- just that publishers generally have to be even less forgiving of the 'quality at all costs' mentality.
In a conversation with an employee on my team today, this subject came up, and we tried to find a parallel in another entertainment industry but failed. I can't think of any evidence of the movie industry (as an example) going through phases of 'profitability confidence' tied to anything other then, perhaps, the global state of the economy. Even with a component of their revenue tied to hardware sales (VHS, DVD) I would bet that the transition period between the two platforms saw steadily increasing average budgets for hollywood movies, a trend that seems to be continuing.
What other industries have their sales (and therefore the content production budgets) limited by the distribution of a 'player'? I have a hard time imagining a record executive refusing to sign off on an expensive accompanying orchestra because (hypothetically) sales of the iPod are slumping -- music revenue is too spread out to be limited by a single factore like that. ABC may be cutting costs on one of the most expensive shows in its lineup, but even if DVD player sales started slumping in anticipation of HD-DVD and/or Blue-Ray (again, hypothetical) the number of DVD players on the market creates a completely different economy of scale. They can probably "afford" to weather a slumping market for DVD sales for a season.