The big UI annoyance is that assumption in #2. Most of the time you did drill-down into this folder from its parent so "back" goes "up". But when you didn't (which could have been hours ago), you get a very jarring disorientation.
Comically, your scenarios #1 and #2 even clash with each other. If you do #1 then #2, the "back" operation goes deeper into the tree. If you navigate from C:\a\b to C:\a\b\c then to C:\a\b, the behavior of "back" is now different based on how you went from b\c to b, whether you did that by "back" or by clicking the address bar link!
The Backspace key always did "up" in older versions of Windows, but does "back" in Windows 7, which annoys me all the time. Alt-Uparrow does work consistently, but my muscle memory isn't there, and it's jarring that there's no symmetrical Alt-Downarrow operation.
The up button was removed in Vista/Windows 7 and has now been re-added. It's not a new feature it's just that most windows users moaned about its removal so much they've finally caved.
All the functionality you're describing is available in Vista/Windows 7.
But the up button? It's just better. You don't know what you're missing.
1. Right click on the folder (so-called "proxy") icon in the titlebar, which will give you links to all the folders up to the root
2. Assuming you drilled-down into this folder from its parent, click the back button or (with a multitouch trackpad) three-finger swipe to the left.