First make output decision based on market price and their cost of production. The latter is determined by the technology employed and the process if inputs like labor, capital and materials used in production. Existing capacity also constrains the maximum possible output that can be produced.
Extending the same logic to the entire economy, we can say that the aggregate supply of goods and services would depend upon the price and some measure of the cost of production. At the aggregate level, we think in terms of the price level, wages and some index of material costs. Supply shocks like weather and oil process would also impinge on the behavior of aggregate supply. Given the technology, the stock of capital equipment and prices of variable inputs like labor and materials, aggregate supply would respond positively to increase in the price level till capacity output is reached.
An increase in wages, materials process or an adverse supply stock like bad weather would reduce the supply of output at any price level. Conversely, reduction in input costs or a favorable supply stock would increase the supply of output at every price level.
In the short run, the main determinant of aggregate supply is the behavior of wages. Wage determination in a market economy has two components. Given expectations about future inflation, workers will try to protect their real wages by demanding nominal wage increase at least equal to the expected inflation. In addition, there is the influence of conditions in the labor market. In an economy which is working at or beyond full capacity labor markets are very tight and workers a demand increase in real wages, i.e. nominal wage increase beyond expected inflation. Conversely, in a recession with high unemployment, workers would tone down their wage demands and perhaps even accept a cut in real wages.
In the short run, the behavior of the aggregate price level is determined by changes in variable costs, viz. labor and materials costs. If wage increases are highly sensitive to prevailing unemployment rates, increase in aggregate supply can be brought about only by a sharp increase in price level the aggregate supply curve is steep. If material prices increase, the curve shifts up causing higher prices at all levels of output.
In an economy like India’s where a large fraction of the labor force is employed in the so called unorganized sector with virtually no unionization and collective bargaining, the wage employment relationship and its influence on the aggregate supply behavior is limited. Aggregate supply is more sensitive to other shocks such as increases in materials prices and weather factors.
In the long run, supply behavior is largely determined by changes in productive capacity brought about by investment productivity increases and technological.
Putting it together:
An economic equilibrium in a market economy is characterized by equality if supply and demand. At the aggregate level too, GDP and the price level are determined by the interaction of aggregate supply and aggregate demand. Shifts in either, caused by police actions and exogenous shocks would lead to change in output or the price level or both If the economy is in a recession, an increase in demand would lead largely to an increase in output with little or no increase in prices. Conversely, if the economy is operating near capacity increased demand would cause a spurt in prices, if the demand pressure persists, it would give rise to persistent inflation. An adverse supply stock would lead to a contraction of GDP and a rise in price level. If wage increases tend to outrun productivity improvements or if materials prices show a persistent upward trend once again inflation would be the outcome.
The dynamics of wages and inflation is closely related to formation of expectations, credibility of policy makers and the level of unemployment.