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Please clarify cross-sells and up-sells with more Magento friendly definition and examples. What is functionality in real life of this taxonomy? How should we use these features correctly to increase sales? Give me more rules to relate/link products with each-other as cross or up-sells. Thanks much.

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In Magento, cross-sell products are displayed in the shopping cart.
The reasoning is, if you place a product in the cart, they want to entice you to add one of the associated cross sell products, also.
For example, some nice wine glasses could be cross-sell products if you are buying a bottle of wine.
In a real life store, think of products at the end of the same isle.

The up-sell relation is to sell a better, newer, or generally more expensive variation of the product the customer is viewing. They are displayed on the product detail page.
For example, if you are buying the Heart Rate Monitor "newgen medicals 4in1" for 24.90 €, the "Wahoo Fitness Bluetooth Blue HR Smart 4031" for 69,90 € could be displayed as an up-sell product.
In a real life store, up-sell products would be placed right beside the other products, but probably a little higher on the shelf, maybe with a nicer display.

Note that this is how Magento defined these type of product associations. In contexts they might be used differently.

  • Real examples help us to orientate right direction while developing some extension or learning Magento. Thanks for this – mageUz Jun 14 '13 at 12:30
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Magento offers by default 3 types of product relations.
From the technical point of view these 3 act in the same way and are just ways to establish relations between the products. (manually in CE and manually + rules in EE) From my point of view they have no meaning by themselves.
Through the default layout magento gives meaning to them as follows:

  1. Upsells. They are listed in the product details page and mean 'You may also be interested in the following product(s)'. Usually here you should include more expensive products in the same area as the main product to convince the customer on buing something else but for more money. See what Wikipedia has to say about upsells.
  2. Crosssels. They are listed in the cart page and mean 'People that bought these also bought...'. Of course that is not exactly true for Magento because the links are made manually (at least on CE). In this list you can present the customers additional products that 'they don't know they need but might want'. Here's Wikipedia again
  3. Related products. They are listed in the product details page and the customer has the possibility of adding them to the cart at the same time as the main product. You might want to list here some kind of accessories for the main product. Example. For a board game you might add an extension pack. For a phone you can add as related a hands-free system. (No wikipedia link on this one).

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