I don't (yet) have kiddos so take this opinion for what it's worth:
Is it really so hard to invite kids outside of the classroom to a birthday party? And why would you (the party host/hostess) want two dozen rugrats in your care anyway if you tried to invite the entire class? At a very young age I had a birthday party at the park with the girls from my brownie troop (girl scouts). There were maybe seven who could attend and that was fine. We played on swings, ate cake, etc. and it was fine.
I will never understand spending hundreds of dollars on a birthday party for a kid that young, who might not even remember the event as a grown-up! Little kids are easy: sugar and playtime and a few friends to enjoy it with.
See, I think that for too many parents, there is little to no contact with other parents in a child's classroom except pickup/drop off and no contact information other than school mailboxes. At our preschool, I have emails for all the other parents, phone numbers for most, and am Facebook friends with many.
At the preschool age, I personally just invite the whole class. There have been several discussions among a couple close mothers about one child, who is the class bully, says inappropriate things, and generally acts inappropriately. That family has declined every invite our out of school activity, so it's a non-issue, but the discussion I had with my son (who is turning 4) is that he can invite three best friends for his birthday or all his friends, including the problem child. He chose the latter.
The teachers are working with the kids to talk about appropriate and inappropriate conversation and behavior. One issue is playdates - I'm going to X's house is exciting to kids, but it hurts those excluded. I felt absolutely AWFUL a month or so ago - I pinch hit for the parents of my son's best friend and picked him up on a day my son was not at school, took him home, fed him dinner, etc. It was last minute, and he wasn't told about it until I picked him up - and since he was a little apprehensive I knelt down and said that we could call his mommy, and we were going to have spaghetti and meatballs and he could ride in my van next to his BFF. Cue tears from two little girls who don't even like the boys, but were sad they were left out.
As for why hold these sort of parties - as painful as small children can be, holding and attending these parties - especially ones where the whole family is invited - helps build social relationships
between the parents, and helps form bonds. Those social bonds can be extremely helpful, as well as beneficial to everyone involved. And it's part of the grit your teeth and manage that comes with kids :-) I certainly cannot stand one mother, who I hang out with on occasion and get together with as a family because her child and my child adore each other, and her husband is awesome and gets along with my husband.