The dungeons in Daggerfall are procedurally generated, yes, but they were procedurally generated way back when Daggerfall was in development, so they are actually the same layout on every playthrough
What DFU cannot do is change these blocks themselves.
Since the World Data Editor's release a year ago, it has been possible to edit dungeon blocks with Unity's editor interface. Someone with enough time on their hand could, for example, take a dungeon block and add objects to its layout according to a specific theme (like an orc stronghold). That block could then overwrite the existing so that all dungeons using it have the changes, or saved as a new one to use in a specific dungeon.
I've often toyed with the idea of taking dungeon blocks and making them fit more their dungeon type while keeping the same layout, but that's a lot of blocks to edit.
It's on the idea list, but I always find something else to work on instead.
Does it just shrink the scale of the place or does it chop off areas and turn them into dead ends earlier than having to run down a huge hallway and through 5 rooms to find a dead end with no objective? What exactly does that do?
Dungeons are made of several pre-built blocks. What the smaller dungeon setting does is keep only one block. As a reference for size, the starter dungeon is one block. So you could say that it chops off all blocks in the dungeon and keep only the one that is specified as the entry point.