It seems to be for any 480i content that has been scaled up (and only scaled) by an external device. For instance, some people are using HD cable boxes that scale all content up to 1080i, but all that's happening is a pure scale with no image processing. That's what Mode 2 seems to be for. However, for a clever DVD player that scales up AND has the equivalent of a DRC chip in it, you wouldn't want to use Mode 2, and possibly not even Mode 1. Likewise for pretty much all decent external scaler boxes.
Also, would it be better for the DVD player to be set at 720p or 1080i before hooking it up to the TV and setting it for Mode 2?
I would assume 1080i. However, as I said, if your player is very clever already, you won't want Mode 2, and you might not need DRC at all.