Here's how I would explain the circuit operation
· Amplifier: amplifies the difference in voltage entering the component.
· Digital output: Tells if something is above the sensor or not. The voltage varies between a high value, which means something is present, and vice-versa.
· Analogue output: Variates according to how close an object is.
· Diodes: Converts AC to DC, plus protects circuit from high voltage.
· Photodiode: The more light there is, the lower the resistance and vice-versa.
· Resistors: R1, R5 and R6 protects respectively LED1, LED2 and LED3 from high voltage. This way safe values are kept. R3 and R4 surround the potentiometer in order to reduce the risk of errors. The photodiode and R2 form a voltage divider which significantly reduce the voltage’s magnitude to make it useable.
· LED2 and LED3: Tell us if something is in the vicinity of the sensor or not. LED2 tells us that nothing is present and LED3 the opposite.
· LED1: Emits ultra-violet light that is reflected on objects in its vicinity and is received by the diode.
· Regulator chip: Stops the voltage from being too big and stabilizes it.
· Capacitors: Soothes the variation in voltage and act as a store of electric charges.
· Potentiometer: Is a sensitivity adjustment.
About the limitations and solutions I am not really sure how to start, as my electronics skills are quite limited. A limitation could be that the circuit is only efficient with small voltages, an other one that this type of sensor only works on short distances? At first glance I would say the photosensor could be improved if we replace the photodiode by a phototransistor. An other idea would be increasing/dercreasing the value of some resistors, maybe add/move ground connection and finally perhaps adding a inductor?
I apologise for being so vague.