- A work of magic realism, the story begins and takes place partly in "a sad city, the saddest of cities, a city so ruinously sad it had forgotten its name", which is located beside "a mournful sea full of glumfish, which were so miserable to eat that they made people belch with melancholy". This city is thickly populated by people, of whom only the lead character Haroun and his parents are ever happy, while in the north of the city are factories wherein sadness is allegedly manufactured and exported. The factories produce air pollution that is only relieved during the monsoon, which also heralds the arrival of pomfret into the nearby waters.
- Most of the Earthly locations present in the book are located in the fictional nation of Alifbay, which is a combination of first two letters of the Arabic script based Urdu alphabet, Alif and Bay and therefore contains many places named after letters, such as the "Valley of K" and the "Tunnel of I (which was also known as J)".
- In the center of the Valley of K is the Dull Lake, which is said in the novel's appendix to be named after the Dal Lake in Kashmir. This implies that Kashmir is the place on which K is based. The Dull Lake itself is the location of the Moody Land, a landscape whose weather changes to reflect the emotions of the people currently present in it. It is the place where the lead characters go at the behest of a corrupt politician, and where their adventures begin.
- The larger part of the plot occurs on a fictional satellite of the Earth's, named Kahani, whose orbit is controlled by "Processes Too Complicated To Explain". These processes enable it to fly over every single point on Earth. Kahani consists of a massive Ocean which is composed of an infinite number of stories, each story taking the form of a current or stream of a unique color. The colours encompass the whole visible spectrum and extend beyond into spectra that are not known to exist. Various islands and a continent are also shown on the moon. The name "Kahani" itself means "Story" in Urdu and Hindi, and is ultimately revealed to be the name of the sad city; a revelation that removes the sadness from the city's people.
- The Moon Kahani is, throughout most of the plot, divided into two sections equal in size, one of which is kept in perpetual daylight and the other in perpetual darkness. The two are separated by a narrow strip of twilight, which is marked by a force field named Chattergy's Wall. The daylight side is called Gup, a Hindi and Urdu word (meaning "gossip", "nonsense", or "fib" in English) and the night-darkened side is called Chup (meaning "quiet"). Inhabitants of Gup value speech and are called "Guppees", meaning "talkative people", while inhabitants of Chup are stated to have historically valued silence and are called "Chupwalas", meaning "quiet fellows". The "u" in "Gup" rhymes with the "u" in "cup", the "u" in "Chup" is pronounced similarly to the "oo" in "good", and the "w" in "Chupwala" resembles a sound lying midway between the English letters "w" and "v". At the South Pole of Kahani is a spring known as the Source of Stories, from which (according to the premise of the plot) originated all stories ever communicated. The prevention of this spring's blockage therefore forms the climax of the novel's plot.
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