Le Guin is stating the formula for the happiness that characterizes the fictional city of Ornelas. She is saying that happiness is based on the ability to tell the difference among what are necessary or basic needs in life, what are simply wants, and what are things that should not be had because they are detrimental.

In speaking about the happiness that exists in the city, Le Guin does not expound upon the first qualification - "what is necesssary," because it is straightforward and easy to understand; in our present day society, food and shelter would fall under this category. The second qualification - "what is neither necessary nor destructive" - calls for a little more elucidation, and the author provides this, saying,

"they could perfectly well have central heating, subway trains, washing machines, and all kinds of marvelous devices not yet invented here, floating light-sources, fuelless power, a cure for the common cold. Or they could have none of that: it doesn't matter. As you like it."

In our modern world, similar amenities would apply here, and it is true that happiness is, to a certain extent, dependent on one's ability to discern between what is a need and what is simply a want.

It is when the author gets to the last part of her original statement that the problem occurs. At first glance, it might seem that determining "what is destructive" is a simple matter - poison and guns, for example, would be things that are inarguably destructive. The problem is that it can sometimes be argued that destructive things are necessary; for example, that poison is necessary to rid one's home of pests, or that guns are needed for defense. The difficulty involved here is the point of the story - the happiness that Ornelas has achieved is based upon the victimization of a child. Some people are able to rationalize this situation with little trouble, but others recognize the deeply troubling dilemma that is inherent in the set up. These are the people who end up walking away from Ornelas, perhaps to ruminate on the subject in greater depth, in search of an elusive answer that is morally satisfactory.