After seven pages of this I just can't resist any longer......
Regarding the right-of-way question, the reg does seem a little vague and open to interpretation. Perhaps interpration could be easier if we considered the rule in the context of the FAA's philosophy regarding right-of-way. The philosophy is really quite practical.
In the air, the right-of-way order is (1) aircraft in distress, (2) baloons, (3) gliders, (4) airships,.... Basically, the philosophy is that the more maneuverable aircraft must yield the right-of-way to the less maneuverable aircraft. This makes logical sense. A plane flying toward a baloon can turn away much easier than the baloon can. The craft with more options yields to the one with fewer options. Simple and practical.
So what does that tell us about a plane on the runway versus one on final approach? Planes are much less maneuverable on the ground than in the air. A plane on the ground can neither ascend nor descend, its speed is rather slow, and its turning options are constrained by the limits of the runway and available runway exits. That plane, as a practical matter, has the lesser ability to yield. The plane in the air on final, however, can yield the right of way rather easily. All the airborne pilot need do is shove in the throttle and go around.
Therefore, it seems reasonable to conclude that the plane on the runway has the right of way. The plane on the runway is still in the process of "landing" until it vacates the runway. Want additional proof? When you land at a controlled airport, you don't switch comms to ground control until you've exited the runway. The tower controls landing traffic, and until you leave the runway you are still under tower control and you are still considered part of the landing traffic.
The CFI in this example blew it, in my opinion. What an excellent opportunity to give the student a real-world, practical example of a go-around situation! My instructors drilled into me that every approach is a go-around until proven otherwise. One instructor told me, "As soon as you even think, 'Maybe I should go around,' shove in the throttle and go. Don't debate it, don't question it, just go around." This CFI had a great chance to teach that, and he failed to do it.