Other World

According to the letters sent to Peter Spear from Derek Karlvaegen this is the name given to earth by the peoples of Daventry. It is part of the Multiverse. Humans in Daventry originally withdrew from the Other World so they consider people still in the other world as their ancestors. Many mythic beings originally came from the Other World and moved into Daventry, and that is why Earth and Daventry share mythology, books and even many of the same heros.

Daventry as a Location on Earth
However alternatively it is strongly implied or even specifically mentioned that the world is on Earth, that events in the King's Quest games occured a long time ago in our past, and the concept of withdrawal is not mentioned. In this interpretation we share the same mythology because we exist in the same world just many generations after the events occured. The refrences can be found in the original manuals and introduction video in KQ6, as well as refrences to world being called Earth by Edward in KQ1 (remake) and gnomes in KQ8, and even Derek Karlavaegen in Guidebook to the Land of the Green Isles.

See On the Origin of Daventry for further information.

Real World
Of course, someone can argue that Earth from where the KQ creatures and people came is not our actual world, but some alternate earth, where gods, myths and fairytale cahracters were real, before withrdrawing to Daventry. Compare to the League of Extraordinary Gentlemen that takes place in an alternate Victorian era, where all literary concepts by Vernes, Welles and others are actual events. Many instances in the books indicate that the setting is not supposed to be a past of our world, but an alternate past, more advanced than our actual Victorian time, for example they routinely send men to mars, and there is a bridge between France and England.

However it should be noted that conceit behind the story is that the Peter Spear from our earth really received these messages from Daventry, and then sent it to our earth's publishers to be printed for us to read, thus why the book physically exists in our world, and not some alternate universe where we wouldn't actually be able to get a copy.

His conceit behind the story is that we the people of earth really did have a fantastic past, and as time passed, that the modern people of earth who believe in science and technology can not accept our "true history", and are writing revisionist history that denies(though they can't "disprove") what "really happened". Compare to various religions of the world that believe fantastic things of mythic proportion actually happened in the past, and that fantastic beings really existed.