The candidate elimination algorithm incrementally builds the version space by processing examples one by one. Each example may shrink the version space by removing hypotheses inconsistent with that example. It does this by updating the general and specific boundaries for each new example. Positive examples generalize the hypotheses space, while negative examples make the hypotheses more specific. The algorithm initializes with fully general hypotheses and processes examples to iteratively refine the version space between fully general and fully specific hypotheses.