the difficulty settigns mainly jsut increase the enemy AI used.
Never go head to head with enemy fighters. Wait for them to break off to extend, and cut in behond them. Remember, the AI in XWA is horrible at deflection shooting (Hitting you from the side) so keep them at your 3 or 9 oclock position until they break off... then they are fairly easy to take out.
As far as Capital ships.. the easyiest way is to dumb fire warheads at them. Otherwise you have to use the "Force Run" technique i have refined