Don't work for blizzard, but software dev / server engineer here. Yes, it is naive and unrealistic when it gets to a certain point of several hundred players in that small condensed space. Was just doing hillsbrad now, with 4 raid groups on Horde and at least 3 on alliance. That's close to 300 people in a small area. With the server tracking every player's casts and positioning and informing that to all the clients - all 300 of them at once, while all 300 of them are also inputting.

For the same reason you can't crank up a knob on your computer and download a 100GB game off steam instantly, there exists a point to where the data coming in and going out takes more time to cause noticeable lag. The more people and data going in, the effect scales linearly.

This is the reason why there aren't many games that even have 300 people in one session possible. I've never seen a console game's multiplayer handle more than 64 players, and it really all boils down to the same reason why your WoW will always lag when there are 300-400 people in your zone