The fairy tale world is where you get the Little Red Riding Hood effect.
As for the creatures in the hut, they can be alive (although they do nothing), but since they are hanged from the ceiling, it's obvious that they have been captured, so there's indeed some kind of conflict.
As for making sense, well, it's not supposed to make sense, it's a dream, after all. Neither of the YN fangames, nor YN, makes sense. And that's why we love them.