Note that we never see both Diane’s at once.
Indeed, and it's the same in 2001. This is achieved by filming the "second version" as if through the POV of the first. Yet, in both films, the two versions make it clear that they can see and acknowledge each other, even though the first disappears and causes us to question what we're seeing and whether or not it was indeed a POV shot.
And speaking of POV shots, this might be minor but I find it interesting... You may have heard of the technique Lynch and the cameramen came up with that they call "Floaty cam" or something like that. It refers to, for example, the scene with Dan and Herb inside Wikies, if you notice the camera, it's in a constant state of slow movement, sort of like a POV shot. It constantly moves slowly in small circular motions (some say a figure 8 motion, like the infinity symbol we see on the ground in front of Club Silencio) instead of staying still. It's used many times in the film. Is this intended to make us feel like they're POV shots instead of objective camera shots? Furthermore, when Dan and Herb go outside, sometimes the walk is shown as if through Dan's eyes (POV shots), but as the POV passes the payphone, the camera turns toward the phone as it walks by. It cuts while still on the payphone, but Dan is looking straight ahead, with the payphone right next to him. In other words, the POV shot does not match Dan's POV. Is it someone elses? Who's POV are we seeing through the second time we travel to the back of Winkies @ night (after the hitman laughs at Diane)?
How do we know Camilla is a hallucination? You’re prepared to accept the second Diane as real (a great proposition by the way), so why not Camilla?
Since the second Diane replaces both Camilla and the original Diane, it's impossible to say what is real or not real. Or, perhaps, it proves that nothing is real, since impossible things are happening, and continue to happen, in this so-called reality. I disagree with you that Diane sitting on the couch is real, because it's the most unreal so-called reality scene. There's the strobe-light effect from Club Silencio happening in her living room, there's the tiny old people. And as she sits on the couch, we hear the sound of her screams
before we physically see her get up and start screaming. Then there's the very unreal way the suicide scene is shown. Even the way the fog pours into the room is very unrealistic, very artificial. We can practically see the fog machines themselves in our mind's eye due to the artificial way the smoke pours into the room.
This is obviously connected to the smoke when the magician disappears. It's the same effect, not just the fog itself but the way it pours out artificially. However, the connection I never see anyone make is to the scene where the bum puts the blue box in the brown paper bag. There is a
fire and smoke pouring out in the background of this scene (and iirc the smoke pours out in that same artificial way).
So the smoke in the suicide scene is not only directly linked to Club Silencio, but also the bum and his fire. This is why these are the two things we see inside the smoke that fills Diane's room. The bum's face, being illuminated by the flickering flames of his fire, and also the stage of Club Silencio. Perhaps this overlaying of things inside the smoke is a reference to the Wizard of Oz, and the illusion he creates inside the smoke and flames.
It's also quite brilliant and beautiful the way that, for a small moment, the image of the Bum, the curtains/stage of Club Silencio, and the bright-white, smiling Betty with the swirling city lights behind her, all merge into one, all visible on the screen at once.

Questions in a world..... of
blue.....
Have you chewed over this thread?
After reading through all 7 pages, I'm surprised no one mentioned the thing that sticks out to me about the "lamp lady."
It has to do with her mentioning the detectives (which also alluded to Betty and Rita snooping in the dream, but I'll get that that later).
If we go with the logical approach, it would seem that LL is covering for Diane. She agreed to swap apartments with Diane to assist Diane in evading the detectives. If this is true, it is very hard evidence to support the idea that Diane and LL have a much deeper history than we think, because it means that LL is breaking the law and making herself an accomplice in a crime... Which implies she cares a great deal for her despite the estranged regard they have for one another in the scene. The fact Diane has so many of her things only reinforces this notion.
Going back to LL's mentioning the detectives alluding to B&R, there's another interesting detail. That really sexy red spaghetti string top that Camilla is wearing in the so-called hallucination in the kitchen, and also wearing when Diane slams the front door shut in Camilla's face... Rita is wearing the very same top under her black cardigan when "investigates" Sierra Bonita.