Basic Econometrics 5th Edition by Damodar Gujarati,Dawn Porter

Exercise 3

According to Malinvaud (see footnote 11), the assumption that E ( u i | X i ) = 0 is quite important. To see this, consider the PRF: Y = 1 + 2 X i + u i. Now consider two situations: (i) 1 = 0, 2 = 1, and E ( u i ) = 0; and (ii) 1 = 1, 2 = 0, and E ( u i ) = ( X i - 1). Now take the expectation of the PRF conditional upon X in the two preceding cases and see if you agree with Malinvaud about the significance of the assumption E ( u i | X i ) = 0.