They definitely are.

I only have two users on my instance, but there are posts with thousands of upvotes.

Beehaw markets themselves as a heavily moderated space and they caught a lot of flack for defederating from Lemmy.world and sh.itjust.works, but even they are still federated with a bunch of different instances. There will probably be a pool of instances that share a fairly hands-off approach and remain connected to all the other instances that have a "we'll federate with anyone" policy. There will likely be a collection of middle-ground instances who defederate with instances that are the source a lot of harassment or certain NSFW material but otherwise don't restrict much and still federate with instances that maintain similar moderation styles. At the far end you end up with places like Gab and Truth Social which are both Mastodon instances that aren't federated at all and are completely closed communities because they only ever wanted to be an echo chamber. The rest of the fediverse or even just Mastodon didn't cease to exist when Truth Social started up its own walled off instance.

People can self select into the kinds of communities they like. The unrestricted ones will only fail if the lack of moderation is such a problem that nobody signs up to any of them.

That's just a slippery slope fallacy. While some instances can be more or less defederation-happy, doing it to some instances does not mean every instance who resorts to defederation will eventually exclude all other instances. Many simply want to cut off hate speech and extreme violent content, and not everyone is interested in having sexual content, especially depending on what sort of stuff it is.

It's alarmism over something that would be normal in most other platforms, which just ban users and groups who post content that goes against the rules of conduct, something that happened even on the tiny niche forums and chatrooms of the past. But rather than being entirely excluded you get to stay in communities that fit your limits. The interaction of instances that are federated will ensure that the Lemmy ecosystem will be less of an echo chamber than reddit itself was.

I think that the problem you describe is self-limiting because users can easily make accounts to get around an instance that limits the content users can view or just add an account for a more permissive instance. However, consider the following: humans tend to fixate on loss, and users aren't tied down to using any particular instance or even just one, so they don't have to compromise. You don't lose anything by adding another account on another instance to your client. There are already clients that let you pull from multiple instances automatically.

Defederation that hurts users, by the judgment of those users, on a platform where it's easy for your users to just join any other competing instances on a whim, tends to select against instances that defederate excessively. That is my hope.

Can I ask how you were "introduced" to .world? Just been wondering why that's the one everyone is moving to atm.

Cheers :)