Read the passage carefully and answer the questions based on the passage:

Increasing return to scale (IRS) implies that if we increase all the inputs by a certain proportion, output increases by more than that proportion. In other words, to increase output by a certain proportion, inputs need to be increased by less than that proportion. With the input prices given, cost also increases by a lesser proportion. For example, suppose we want to double the output. To do that, inputs need to be increased, but less than double. The cost that the firm incurs to hire those inputs therefore also need to be increased by less than double. What is happening to the average cost here? It must be the case that as long as IRS operates, average cost falls as the firm increases output. Decreasing return to scale (DRS) implies that if we want to increase the output by a certain proportion, inputs need to be increased by more than that proportion. As a result, cost also increases by more than that proportion. So, as long as DRS operates, the average cost must be rising as the firm increases output. Constant return to scale (CRS) implies a proportional increase in inputs resulting in a proportional increase in output. So the average cost remains constant as long as CRS operates. It is argued that in a typical firm IRS is observed at the initial level of production. This is then followed by the CRS and then by the DRS. Accordingly, the LRAC curve is a 'U'-shaped curve. Its downward sloping part corresponds to IRS and upward rising part corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed. 

In which condition, the average cost of a firm declines when output increases?

Increasing return to scale.

The correct answer is Option (4) → Increasing return to scale.

When a firm experiences increasing return to scale, output increases by a greater proportion than the increase in inputs. Since inputs and therefore costs rise less than proportionately to output, the average cost of production falls as the firm expands its output. Hence, during the phase of increasing return to scale, the firm enjoys economies of scale, leading to a decline in average cost.