I guess this a good time to resurrect my theory from C&C, with pictorial support.
DISCLAIMERS:
Do not read this if you haven't seen the movie.
I'm not sure I believe the puzzle can be entirely solved.
I'm not claiming this was Lynch's intention.
So here's the theory:
The dream is Diane's creation, but Rita is having the dream. Betty is Diane's ghost. Her purpose is to fix the mess she helped create before her death... to alleiviate Rita's guilt, put the world back together for her in a manipulated frame, and bring her back to full consciousness.
Diane isn't falling asleep in the first red pillow scene.
She's dying.
Rita falls asleep for the first time.
CUT TO:
Rita's dream begins.
Surreal and almost absurd.
Rita falls asleep again, under Aunt Ruth's kitchen table.
CUT TO:
Rita's dream continues...
...with the Winkie's story, even more surreal.
CUT TO:
Rita, still asleep.
CUT TO:
Mr. Roque introduced.
Up to this point, Rita's visions have been pretty vague, unconnected, and entirely non-poigniant. They must be shaped to mean something.
Enter Betty, precisely when Diane (chronologically) would have killed herself.
After Betty has met Rita and has becomed concerned about her...
...she puts Rita to sleep, placing her hand on her forehead,
infusing a dream directly into her headCUT TO:
Adam Kesher's story begins.
This is the real beginning of Rita's detailed dreams. A completely absurd and overelaborate conspiracy is blamed for Camilla's success, and indirectly, Diane's dejection... when it was really Camilla's fault. History is rewritten, and Rita's guilt is gone.
CUT TO:
Just a reminder, Rita is still sleeping/dreaming...
...and Betty touches her forehead again.
CUT TO:
Mr. Roque's story continues...
...this time with more detail, and a connection to Adam's story & the larger conspiracy.
CUT TO:
The Black Book...
...with reference to the car crash and the conspiracy.
Rita wakes up.
Betty encourages Rita to find her identity.
Betty points out the waitress' name (even saying it slowly and clearly)...
...thus getting Rita to remember the name "Diane."
Betty gets Rita to help her practice her lines in an angry scene...
...deliberately giving Rita a glimpse of Diane.
Adam sees a ghost...
...then agian, he's not really there either.
Betty encourages Rita to fear conspirators.
Rita tries to stop Betty from knocking...
...but you can tell from the look on Betty's face that she knows more than we think.
"I guess you're not Diane Selwin"...
...pushing her further towards an identity.
When Rita sees Diane's body...
...Betty's purpose is not to be shocked, but to support & expose Rita.
Diane holds Rita's hand...
...and Rita starts saying "silencio"...
Diane gives the blue box to Rita...
...(Rita does not discover it.)
Right before Rita opens the box, Betty disappears...
...because she is no longer needed.
As Diane pushes her out...
...Camilla's guilt is obvious.
In some of the last moments of her public life, Diane collects characters.
And finally, Adam's hair changes
in the middle of the party scene--
