Since this topic has come up in a couple of threads, I wanted to put this in it's own thread.
I don't know how they do it now, it may be by computer- but when I was taught pattern grading by hand back in the stone ages this is how it was done:
You start with a standard sized pattern (size 8 was what we used) in cardboard. You used a little device which consisted of a weighted base and two thin metal arms attached to graded dials. One dial moved the arms in or out, the other up or down. You begin by taping the first pattern piece of the garment to the grading device and tracing it. For each type of garment, there is a set of instructions for sizing up/down. So, for a blouse on the sleeve piece; you first move up 1/8" and mark the top of the cap. After each move, you moved back to the original size, then to your next move; out 1/4" and mark the underarm point, etc. You continue in this manner until all points on the pattern are marked, and then you use drawing tools (rulers and curves, etc) to connect all of the marked edges in a smooth line. This is now the outline of the new size. This is a tedious process, and you can begin to see how it has limited success, and why sizing breaks are necessary. One reason, of course, is that as you venture into plus sizes, you no longer need extra length as much as width. This is also why short/tall or inseam length sizing becomes important. Not everyone expands out or round at the same rate that they grow taller.
One fluid set of a larger range of sizing, such as Old Navy is now carrying will be sized for specific fit models, as all clothing lines are. The best case scenario is that the fit models they use will be the most typical body shapes/weight distributions and that their patterns will allow for the widest array of figures to fit into their sizes.