With so much power and memory etc it is obvious (as you said) that an operating system is just another application and you then run an application within it
Yeah, in the context of a VM, the guest OS runs as if it's an application on the host OS. And then other applications within the guest, as you said.
Example: When I want to run Microsoft Office for Windows on my Mac, I have these layers going:
Alternatively I can have the Windows desktop be the application that appears on OS-X, and have the Office app appear on the Windows desktop.
So exactly as you said -- the guest OS is just another application, and you run an application within it.
Of course, my example only happens to use a Mac for the host. You can do the same thing on Windows or Linux hosts. It's kind of a kick to run Win95/98 (as a VM) on speedy modern Windows PC hardware. It's unbelievably fast, and it makes for some interesting double-takes from friends.