Final answer:
If average cost is decreasing, marginal cost must be less than average cost. This means that as additional units are produced, they are costing less to produce than the average cost of all units produced before them. Therefore, each new unit lowers the overall average cost.
Step-by-step explanation:
If average cost is decreasing, the correct response is that marginal cost is less than average cost. This economic principle is based on the relationship between marginal cost and average total cost. As long as marginal cost is below average cost, the average cost will continue to decrease as each additional unit is produced at a lower marginal cost. Conversely, if marginal cost were to be above average cost, it would pull the average cost upwards with each additional unit produced, leading to increasing average costs.
To put this into context with a real-world example, let's say a firm is producing five units at a total cost leading to an average cost of $26/unit. If the price the firm can sell each unit for is $25, this means the firm is not making a profit, since the selling price is below the cost to produce each unit. If the firm decides to produce another unit and the marginal cost of producing that unit is $30, the firm's losses will increase, since they are selling each unit for a price ($25) that is less than the cost of producing it ($30).