It works like the real world (i.e. North Korea cutting itself off from everyone else, or countries boycotting/cutting relations with others), which is the perfect model in my opinion, or the nearest to perfect as is humanly and realistically possible.
You shouldn't be exposed to or forced to interact with people, opinions or content you don't want to see. Want to interact with Nazis (which most instances block), feel your federation is too restrictive or disagree with their direction or rules? You can seamlessly migrate your account to another instance (or make an alt account). You can even spin up your own instance – your very own social network – if you want to, and federate with other instances as needed.
Centralisation in social media is a very unsustainable model, and impossible to effectively moderate a platform as you have a single central entity trying to be everything for everyone, and people and cultures are very different and have different ways of perceiving and viewing the world and others. Each side or party always feels the platform is biased against them, no matter what. Lengthy thread explaining all of this really well: https://twitter.com/yishan/status/1514938507407421440
The internet was always meant to be and is decentralised, and the same should apply to social media. A platform's role should be to simply provide the network and tools for people to communicate, and end at that. The social part must be up to and controlled by the people. The issue with all current platforms like Twitter/FB is they try to control the social part and how people should interact with each other, and then there's AI and algorithms which is an entire thing and issue in itself as well where you have a corporation employing surveillance capitalism and controlling what you see and what you think.
Mastodon has no ads and no personalisation algorithms and strongly sticks to and follows ethical and humane design principles where only you control what you see.