How does the OS know to ignore the data behind the actual newly flashed data?
Is it because the partition was made small and just happens to live in a somewhat larger partition?
Well there is a distinction between partition and filesystem, and they normally do not have any information about the other. The partition size never changes, but you do have the possibility to change the filesystem image size.
What you flash with Mender is a filesystem image on to a partition, the filesystem image holds all the necessary information (size etc…) and this is what the OS interacts with. Mender will make the check if your filesystem is larger then the allocated partition, but there are no problems if it is smaller.