Technically supply does diminish. People like to calculate the market cap of Bitcoin based on the theoretical amount of them in existence however people lose their wallet.dat files all the time which contains the password allowing someone to send those bitcoins elsewhere. This causes deflation to occur on top of the regular limit on the amount of bitcoins.

Tldr; Bitcoin is deflationary because math.

Well, it's totally possible to lose a btc irrecoverably.

Secondly, at some point, calculations become onerous. Like, if btc is $100k/coin, then normal, every day transactions will need to be in 0.000001 coins. Which is an incredibly annoying unit to work with, it's trivially easy to miss an order of magnitude, i.e., 0.0000001 at a glance, is that a dime, a dollar, or a ten?

Accidentally give a $100 instead of $10 once, and you'll be annoyed, do it twice and you're done using btc.

mBTC: MilliBitcoin - 1 thousandth of a BTC uBTC: MicroBitcoin - 1 millionth of a BTC

Further details: http://bitcoinchaser.com/bitcoin-units-and-denominations