Let's test your assertion which says that something with only 2 steps must be bad. Ok.
For instance, SACD home systems use a 1-bit playback DAC. Yes, they oversample, but in that revelation lies your failure to understand how it all works. SACD uses oversampled, noise-shaped PCM. Yes, boys and women, that's all SACD is, an inefficient form of PCM.
When you have no oversampling, it is still entirely possible to switch that 1 bit (2 level) system so that the resulting sound is pure white noise. That's what dither is supposed to do, and what it does perfectly well when it's done properly.
As to your illusion of steps, don't forget that there is a reconstruction filter in any DAC, so you don't actually see the steps in any case.
You are operating from a point of view that has been intentionally propagated by some completely irresponsible authors and bloggers, which I am not blaming you for, HOWEVER, I must advise you that you are flat-out wrong in your assertion that you MUST have granularity at low levels in PCM.
SACD is a perfect example of how that has to be wrong, since it's a 1-bit system that is oversampled, yet lacks granularity. And, yes, it's oversampled PCM with quantization noise shaping, nothing whatsoever more or less, despite all of the hype and claims about it.
Sorry to be picky but not sure SACD is a good example JJ; mainly because it is closer to PWM (being PDM if really being picky) than PCM.
This is an important differentiation between PCM and PWM as they behave differently in terms of use.
Yeah it is unfortunate the concept of understanding the steps in digital is subtly misrepresented by some sites, but then I feel Monty and others do something similar as well to create the narrative that there are no steps (whether physical or theory functional) or how sampling rate has no effect on resolution; both camps are missing the finer details as each are trying to present a narrative.
Mark,
as JJ says you will never see actual steps at the final output stage due to filters and all music is dithered, however there is one example where you will see steps and that is with NOS DACs (this is in reality alias images but will look like steps), but importantly it is interesting no-one has ever mentioned fatigue/graining/etc with any of the NOS DACs they either own or when auditioning.
That said due to the nature of NOS DACs, they are limited to roughly 17bit resolution at very best and more average examples can be as low as 14/15bit.
IF music or sounds were done without dither (remember all studios will use a dither process-stage) then at lower amplitude (when very quiet tone) you would see the step-squares as you say; this is why from a technical point calculating distortion/noise/etc can be volatile between magazines as there will be subtle differences between using a dithered tone and one without.
The transfer funtion/quantization does create errors/distortion but this is masked with dither; so in theory one "might" say digital is not truly perfect because it requires a further artificial source of noise (dither) combined with the actual original signal.
This is where another debate will be between various camps; how much influence if any does dither and the types used/if applied frequently/incorrectly by studio/etc have on the music listened to - such discussions have already been covered by everyone here so no need to go over old ground I say.
Anyway worth remembering;
Greater sampling rates allow greater flexibility and more ideal filters and provides greater FR for complex musical sounds - greater sampling rate does not improve resolution per se.
Greater bit depth lowers quantisation errors-distortion even further at lower signal levels (closer to -96dBFS rather than 0dBFS) and provides greater dynamic range - very subtle distortion-noise difference between 16-bit and 24-bit at say -60dbfs and lower but mostly academic due to dither.
Look at graph 13,14,15 for an example of bit depth with
undithered tone :
http://www.stereophile.com/content/dcs-vivaldi-digital-playback-system-measurements
Another good example would be the HiFiNews measurement that is only in their physical publication showing subtle difference between 16-bit and 24-bit signal relating to noise-distortion against signal level (0 dBFS loud to -120dBFS incredibly quiet).
Cheers
Orb