How does setup.py work?

[dxm]

I am a new comer to python.
I am wondering how setup.py works.
For example, I have a directory like this:
/
   setup.py
   mymodule.c

where setup.py is:

from distutils.core import setup, Extension

mod = Extension('mymodule', sources = ['mymodule.c'])

setup (name = 'Package',
       version = '1.0',
       description = 'This is a demo package',
       ext_modules = [mod])

The correct way to install the newly created extension module is to
type
python setup.py install instead of executing those statements in
python shell, isn't it ?
My question is how additional arguments like 'build', 'install' are
passed into python and how
can I install it from interactively from python shell