To answer the first question, you technically can put the file wherever you want, however you will have to code it yourself, as the default place the file goes to is the first of your two examples. (link to how to do it yourself)
As for the second question, it depends on how you deploy the application. If you deploy via a .msi, then there are two hashes in the properties of the setup project (that the msi is built from), the 'upgrade code' and the 'product code'. These determine how the msi can be installed, and if it upgrades, overwrites, or installs beside any other version of the same application.
For instance, if you have two versions of your software and they have different 'upgrade' codes, then to windows they are completely different pieces of software regardless of what the name is. However if the 'upgrade' code is the same, but the 'product' code is different then when you try to install the 2nd msi it will ask you if you want to upgrade, at which time it is supposed to copy the values from the old config to a new config. If both values are the same, and the version number didn't change then the new config will be in the same location as the old config, and it won't have to do anything. MSDN Documentation
ClickOnce is a little bit different, because its based more off of the ClickOnce version # and URL path, however I have found that as long as you continue to 'Publish' to the same location the new version of the application will continue to use the existing config. (link to how ClickOnce handles updates)
I also know there is a way to manually merge configs during the install of the msi using custom install scripts, but I don't remember the exact steps to do it... (see this link for how to do it with a web.config)