Both at once.
Loli can refer to either sexualized children characters or women who are petite and look like children. This leads to a lot of confusion, and certain art styles in manga/anime can make characters look even younger.
There are artists who have been arrested for using real children to make lolicon, in some cases, their own children. That is more of a serious issue to me than any r-rated doujinshis that have lolis in them.
The issue is further compounded when the West/Americans label anything a day below 18 a "child", when it's clearly not the case. I have seen drawings of busty JKs being labeled child pizzas and if you're attracted to that you're a pedo. Yet most women finished their puberty around 14 and they're not growing much more than that. Making 18 the legal age is the definition of a social construct, a pretty recent and arbitrarily one too. Sexualizing what we call teenagers nowadays is not a Japan only thing, the whole world does. Hell, Americans were once the leader with their sexy blond cheerleader archetype.
I'm not saying adults should go sleep with teenagers but it's more of a mental thing and not physical. We all know 14-16 something are horny as hell and fcking like crazy. The ones who don't are not able to sleep around, not because they want to stay celibate. They're at an age where they physically want to procreate, that's just biology.
As for the whole Loli thing, i would say part of it is a disconnect between the West and the weight/height standard in Asia (that translates into manga/anime). A woman can be considered perfectly normal in Asia yet appears as a "loli" to fat western feminists because she doesn't weight 100 kg at 1,5-1,6m. The average east Asian woman wants to weight around half that so no wonder they think she looks like a "child". As for actual drawing of lolis, as long as it's not an extreme case like you said where actual children were harmed to produced it, i think it should be allowed.
