Whooo boy, this is a complicated subject. It would be simplified if I knew exactly what you wanted set up because then I wouldn't have to cover each permutation. 🙂
First, you are right about library files. iTunes works through library files. It keeps tracks of what you have in your collection, what is in which playlist, where the files are, etc. Then there are the media files which are the actual music files. Under default condition iTunes keeps these all carefully organized in an iTunes folder in each computer account holder's directory.
HT1203 has each person put just their media files in an area accessible to all, but keeps them separate from everybody else's. Each person retains their own library file so they can do their individual playlists for example. If they want somebody else's music they can add the other person's media to their library by dragging the other person's media file to their iTunes. It will the tracks to their library. So yes, the first step is setting putting a media foleder in a shareable location. Each person does that. The second step is each person going out and adding other people's media to their library file.
There are several questions I have for HT1203 that I could answer by experimentation on my computer but I don't feel like investing the time (to be honest). For example, normally when you add a track to iTunes that is not in your media folder, iTunes will copy it to your media folder. Does that mean each person ends up duplicating the other's collection because it copies it to it? The article does not tell you to disable "copy files to media folder when adding to library" in iTunes' preferences. You wouldn't want to do this because what would happened then if you added something to your own library. I guess the way to get around this issue would be to hold the option key and drag the other person's media to your library which would cause it to add it but not copy it. There's more advantages and disadvantages but I am getting tired of typing.
A variant of the above is to merge all the different media folders by consolidating them. That's mentioned as a part of http://support.apple.com/kb/HT4527 Consolidating copies the selected files to the location set in iTunes media folder preferences and iTunes keeps track of where they have moved. iTunes is good at keeping track of moved tracks if they are on the same drive but it it cannot follow them if they are copied between drives. Because you want to also move their collections to an external drive and iTunes cannot keep track of them if you do that, you cannot simply drag the media folders to a shared location as in HT1203, otherwise all their libraries would end up saying they cannot find the files. You must consolidate them to that drive for their libraries to keep track of where the files are going. They can then add the other people's media from their new homes on the external.
Frankly, you can do just about anything with iTunes once you understand how it works. I have in the past kept media on two different drives and would move it around all the time without problem because I told iTunes to not bother organizing or my media, I would do it myself.
I'll give myself a typing break now. 🙂