Habitat degradation is predicted to exacerbate competition for critical resources; however, the relationship between habitat quality and competition is poorly understood. In this study, we used a manipulative experiment to test the effects of habitat degradation on competition between two planktivorous, coral‐dwelling damselfishes, Chrysiptera parasema and Dascyllus melanurus. Experimental reefs were constructed with either healthy (100% live) or degraded (10% live) Acropora longicyathus coral, stocked with varying densities of these two fish species, and monitored for two months. On healthy habitat, the mortality of C. parasema was density dependent, and increased substantially in the presence of the dominant interspecific competitor D. melanurus. In contrast, on reefs where habitat was degraded, C. parasema mortality was highly variable, density independent, and was no longer influenced by the presence of dominant competitor D. melanurus. Behavioral observations revealed that agonistic interactions for both species increased with density on degraded habitat, but not on healthy habitat. In addition, on degraded reefs, both species displayed a reduced association with reef habitat and ventured further away from shelter with increasing densities of the dominant competitor D. melanurus. These results suggest that reduced habitat quality can have such a profound effect on reef fishes, that it eliminates density‐dependent mortality and competitive dominance hierarchies, thereby substantially altering the mechanisms that structure reef fish communities.