Not gonna lie, I saw the video and couldn't figure out why she was wearing the dress that she was. Was it so bad that it needed to be pulled from television? No, in my opinion, but it was not appropriate for the show at all. On Katy's part I really think she was deliberately trying to be provocative, which is sad but necessary when your music sucks as badly as hers does.
But yeah, c'mon. That shit scarcely covered her nips and to me that's not really the kind of thing you wear on Sesame Street if you want to show respect to your audience. Are kids exposed to boobs all the time? Yeah. Are boobs inherently naughty and evil? No, far from. But do kids constantly need to be bombarded with highly sexualized images and scenarios (agreeing that the flirting with Elmo was awkward,) even on Sesame Street? I really don't think so.
If I were a parent I think I'd be pissed to, but I don't think I'd try to get it pulled. I'd probably just try to talk to my kids about the boobage (if they were open to it, kids are pretty squeamish about that stuff sometimes) and see what they thought of it, etc. It's more useful to them in the long run since two dimensional, hyper-sexualized female pop stars aren't going anywhere and all genders need to learn to form healthy attitudes toward sexuality and gender in spite of these images.