It's not quite like an MMO "instance" where everyone teleports off to a cave or something to beat a boss in a raid
In Elite - in Open every player is an instance. When you log on, the Matchmaking servers look at your connection quality, physical location, and in-game location. It then looks up a list of Islands to see if there is one available for your instance to join with. If you are flying around in the middle of nowhere in your instance of 1, you will find nobody else so your instance will stay at 1, and you may be allocated as your own Island owner.
Say your friend logs on soon after you, and is relatively nearby both physically and in-game. He will be in his own instance, but the Matchmaker will see that You have an Island so he will be assigned to it. He jumps to the system you are in, your instances will merge, and you can see each other in-game.
Mister Dialup also logs on. The matchmaker server looks at his connection and has a heart attack. It puts him in a different Island. He jumps to the same system you and your friend are in, but his Island is separate so his instance will never merge with yours. He could be parked in the same station as you. You'll never see him, ever.
Now you and your friend get bored and head back to civilisation. You jump into a populated system, and there are heaps of other players. The player with the "best connection" and owns the Island will have you two join his already populated instance, and you will see every other player in it, up to the instance limit. If further players arrive, they will be in a different instance and you'll never see them - but if you all go far enough away from a full instance, you will all be able to join up until the instance limit is reached again.
I'm bad at explaining things, sorry.