President Trump was both lucky and smart this week in his approach to the thorny issue prescription drug pricing. Lucky, because a district court threw out on First Amendment grounds his executive order that drug companies supply list prices for all the drugs that they produce. Smart, because at the eleventh hour he decided against issuing an executive order that would have required pharmaceutical companies to offer a system of “most-favored-nation” pricing, which would cap the prices that drug companies could charge in the United States to the lowest price charged for that drug in any country outside the United States. Eliminating poor price signals is a modest benefit. But the implementation of the executive order would have slashed revenues, putting pharmaceutical companies at serious financial risk and perhaps ruin.

The basic flaw behind both proposals is that they assume that there is a unique “price” at which pharmaceutical drugs sell. That assumption often works in competitive markets in which the costs of development are low relative to the marginal (i.e. additional) cost of production for each unit. But so-called marginal cost pricing does not work for new pharmaceutical drugs whose development costs are already high and getting ever higher. Companies are constantly researching and trying to develop new drugs with strong therapeutic properties and tolerable side effects. They also face huge costs in shepherding promising drugs through three stages of clinical trials, each one more complicated than the last. Many promising new drugs wash out in these clinical trials, which means that a pharmaceutical company can remain solvent only if its blockbuster drugs yield enough revenue to offset the costs of its duds. And finally, companies incur huge financing costs as they bring drugs to market. Development and clinical trials take years to complete, and drug companies have to find ways to finance expenditures made in year one with revenues that will only start, typically, some eight to 10 years later.