What is the significance of the setting in Hamlet?
why does it take place where it does?
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The question of why "Hamlet" is set where it is and the significance of the setting are very different questions! The why comes from the text Shakespeare used as raw material for his play, which was a historical account of Denmark by Saxo Grammaticus. That's where the story came from, and viewers might have been familiar with the story, as they would have been for other stories Shakespeare adapted.
Now, as far as the significance, that's different. Look at the smaller setting: the castle, enclosed, a tight world where everyone's around one another and always on display. Hamlet grew up there, and knows it well, yet he finds it subverted and changed through his uncle's action. The familiar and known setting is completely transformed, making this a truly weird place for him.
The motifs of spying and deception in "Hamlet" are helped along significantly by the setting. In general, the close quarters of the castle provide great opportunity for much eavesdropping. However, a closer look at specific scenes highlights even further Shakespeare's use of setting to achieve these themes. For instance, the very opening of the play reeks of deception and mistrust as the guards who are friends still must question who is approaching before any trust if offered. This is due to Shakespeare's setting the opening at night, and allows the audience to immediately perceive a sense of mistrust, which will lead to deception later on.
Another scene which demonstrates the significance of setting is the gravedigger's scene. What better place for Hamlet to espouse his existential ideas on the meaning (or lack thereof) of life than in a graveyard surrounded by bones of the dead?
I will join gbeatty in that the setting is defined by the origins of the tale which are to be found in the Historia Danica, but I think also that it is important because it butresses the feeling of dissension. We must not forget that the king used to represent the divine authority on earth. Thus, his castle is the throne of that power. Being what it is, that place must remain pure, never to be corrupted or stained, nevertheless it becomes the theatre of murders, poisoning, betrayal and the very place "reeks" as said eabettencourt but not only figuratively but literally, as Hamlet hid the corpse of Polonius somewhere inside it. He said himself to Claudius that they are going to smell Polonius. Thus, the "throne of power" is totally disrupted, it loses its sanctity and is corrupted. The result is the spreading of an atmosphere of anarchy everywhere in the kingdom (remember the war taking place) that goes hand in hand with Hamlet's apparent insanity and the anarchy swaying his mind. To put in other words, if the royal castle is corrupted and disturbed so is the whole country. And this overwhelming insanity intensifies the effect of the madness of Hamlet on the reader. By the way, Hamlet is the one who is supposed to bring back order yet he is like the rest and we have to wait for another saviour by the end of the play.
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