it’s actively hiding an instance as if it doesn’t exist

For the purpose of directing new users, who tend to just pick the largest instance, sure. But if you and they are both federated, there’s no difference in the content.

So what do they do when the next instance gets “too big” for their liking? Hide it, along side LW? And the next?

Correct, because this increases the reliability of the average lemmy user’s experience as one point of failure affects fewer users.