There's an interesting post over at Voyages in Eternity which asks what the preferred population density of a city should be. This ties in nicely, as well, with a post Tobold did this morning asking how to deal with falling server populations in WoW. Both of these, in some way, address the question of ideal population density in a game. Of course, they aren't identical, as the problem in WoW is that many quests are group quests, and those can't be done if you are all alone in an area. There does exist a way to combine the two questions to a degree, as you could set up NPC adventurers that could help you with group quests.
I am of the opinion that cities should be as densely populated as a 'real' city would be. This is especially true if there is going to be player housing. Random scripted events between citizens makes the game more fun, IMO. I like to see that the metalworker is stopping by the bakery for coffee before heading to the forge.
This holds true for quests, as well - I hate the fact that the quest villagers simply wander around in straight lines or circles. Hate it. Introducing cyclic events in those quests makes them more interesting - if you do the quest three times, and every time the people are in different places, going about their business, it makes it just a bit more challenging - and interesting.
The poster over at ViE notes that empty towns do "make it easier to 1) maneuver through the streets and not become distracted/lost, 2) find what or who you are looking for, and 3) highlight 'important' NPCs and other PCs, as opposed to those that have nothing to directly offer to the ongoing activity of the character". But this implies that the end game is the goal, whereas for some people, all those little side notes are just as much the goal. It depends on whether you are end-game focused. Certainly if I were creating a character for crafting, I would love to be able to set up a shop, or befriend a shopkeep, and know that the populace at large were buying my things.
And don't get me started on the shops in WoW where there isn't even a shopkeep. Argh!
Outside of towns, it gets trickier - it's much harder to believe you're doing an awesome quest that only your heroic character can do if there's a queue to get in to the instance, and a mob of folks hanging out waiting for other party members. But you do need people to pick up group with. And chat with. Etc.