LZW compression is a lossless data compression algorithm that replaces repeated sequences of bytes in a file with a shorthand code. The algorithm builds a dictionary of strings and their associated code as it encodes the input data. It parses the input into strings, looks up each string in its dictionary, outputs the code for matching strings, and adds new strings to the dictionary. For decoding, it expands the codes back into strings using the reverse dictionary lookup process. The example shows how the input string "AABABBBABAABABBBABBABB" is encoded into codes representing the parsed substrings.