You're right. I think "unstated, untested assumption" would be better than "flaw" in that context. If indeed it turns out that a simulation can be more compact in its host universe, then maybe everything really is a simulation, and it's simulations all the way down to infinity. But this would defy my intuitive sense of the nature of reality (derived from things like the conservation of matter and energy, and the geometric idea that four inches of space won't fit within three inches of space), and would effectively allow infinite computation within a finite space.
Well, I'm fairly certain that what we know about physics so far bars 1:1 simulation of this universe at 1:1 speed using anything less than all the atoms in this universe (not much of a simulation then, eh?) But we might be able to devise a simpler physics that still supports intelligent life. :)
You could make some approximations. That's pretty much the core of the argument. It's somewhat implicit that the true nature of the containing universe is not granular like ours.
