How will lemmy instances survive if they get too big?
I know there's donations and the owners can use their own money, but there's a limit. I doubt a platform with hundreds of thousands of daily users can survive with only donations.
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By having more instances and better user distribution. Running a small-ish instance isn't very expensive, around 5-10 euro a month (some VPS providers are cheaper, etc). As Lemmy development continues, and more optimizations come in, these smaller lemmy instances will be able to support more users.
There is also a discussion on GitHub to introduce user and community migrations between instances. So once that feature is implemented, it will be easier to redistribute everything across all Lemmy instances.
Is there a point where there are so many instances that propagating all that data is too taxing and worse than having fewer bigger instances?
Yes, that becomes a concern as the network size grows and the amount of aggregate replication traffic increases. Mastodon has like 10x the server count of Lemmy, though... so that's hopeful. They do use ActivityPub differently though, it possible that federation scales differently between them.
This GitHub issue has a lot of good (but rough and high-level) thoughts on future scaling techniques: https://github.com/LemmyNet/lemmy/issues/3062