Expansion certainly has diluted talent, but this had a bigger effect in the 1960s and 70s when the league went from 16 teams to 24 teams (50% more players!!). Nowadays this is offset and completely countered by the number of foreign-born players in the league, particularly the Asian talent pool which was non-existent back then. Latin American players were common in the 60s, but not like today.
One factor is diluting the pool has been contract exclusivity that prevented athletes from playing other sports, even recreationally. 50-60 years ago, there were players whose off-season job was another sport. Now, we don’t see that at all. And since other sports often have a faster path to the top level, many athletes choose them over MLB. Former NFL quarterbacks Drew Henson, Chris Winke and Cody Brennan all toiled for a few years in the minors before retiring from baseball to focus on football. Former Blue Jay second baseman Danny Ainge made MLB at a young age, but struggled mightily and instead chose basketball.
I think this is a big part of the reason African American athletes are so sparse at the MLB level - a lot of them found a faster path to the top levels in other sports and were talented enough to make it happen…