In certain competitive situations, risk-seeking strategies dominate risk neutral and risk averse strategies. By recognizing and controlling naturally occurring risk-seeking situations, governments can prevent unnecessary risks and optimize the competitive environment.
In the popular board game The Settlers of Catan, players compete by collecting resources when their numbers are rolled. At the beginning of the game, players start with two sets of two or three numbers. They collect resources whenever one of their numbers is rolled on two dice. Players can choose sets that are disjoint, but they can also choose sets that overlap. If their sets overlap, players collect on fewer numbers, but they collect two resources every time their number is rolled. Owning two of the same number increases risk, and does not necessarily increase expected value - it is a risk-seeking strategy. In Settlers, this is often (but not always) the dominant strategy.
To see why, consider a three player game played by flipping a coin each round. Suppose Player A gains a point each round, Player B gains two points on each heads, and Player C gains two points on each tails. The player with the most points at the end of the game wins. Regardless of how many rounds are played, Player A always loses. Observe that even if we make A’s expected value slightly greater than B’s and C’s, A will still always lose a single round game. Although A will come out ahead half the time in a two round game, A’s chances of winning are less than those of B and C for any other small finite number of rounds. Only when the number of rounds is some large number will A’s strategy beat the risk-seeking strategies of B and C.
The game dynamics of Settlers are very similar. In fact, as more players are added to the game, risk-seeking strategies become more and more powerful.
These sorts of situations pop up everywhere in reality. The strategy that produces the best long-run results most often is a risk averse strategy that uses the logarithmic utility function (see Kelly Criterion). But, we might imagine many situations (think Settlers, entrepreneurship in emerging industries) in which firms are incentivized to use risk-seeking strategies. Luckily, at the firm level, we usually don’t have to consider any of this: it is commonly assumed that investors are well diversified and individual firm risk is reduced to zero. Under this assumption, firms must adopt a risk neutral operating strategy and maximize their expected value. Note that a firm’s operating strategy is not the same thing as its financial strategy. Two problems arise from this. First, is the principal-agent problem: the management of a firm might use a more risk averse strategy because they are worried about their jobs (but, often they will use risky strategies for such reasons as overconfidence and likely bankruptcy). Second, and a much bigger problem for society, is the fact that the assumption of risk neutrality for firms is simply not true for all firms.
There are situations in which risk aversion is best strategy for a firm and its investors. Consider Lehman Brothers, whose bankruptcy is often cited as a major cause of the recent financial crisis. Their pre-bankruptcy strategy may very well have been the expected value maximizing strategy. From where I sit, it’s not clear to me that their operating strategy was not the best strategy ex ante, but most people would agree that it was a mistake. Regardless of whether it was a mistake or not, it is clear that the best operating strategy for a firm with as much market clout as Lehman Brothers is a risk averse strategy. This runs directly counter to the generally accepted assumption that firms should use risk neutral operating strategies. Governments must look out for such situations and regulate them ex ante. Ex post solutions such as bailouts are suboptimal - they should almost never have to happen, and should they happen, they should not come as surprises (i.e. there should be an established bailout fund beforehand).
Situations that incentivize risk-seeking strategies occur in both politics and international competition and can be extremely dangerous. In politics, the effectiveness of risky strategies can cause minority policies to be adopted and undermine democracy. As for international competition, the Settlers example is instructive: poor national governments are often incentivized to adopt risky high growth economic policies over risk averse long run optimal strategies. Whereas risky strategies are often OK for firms since their investors are well diversified, national populations are never diversified - they are 100% invested in their country. Failed strategies result in collapsing governments and widespread poverty. Failures also create negative externalities for other nations, who (as the in the financial bailouts) try to fix the problem ex post. We need to acknowledge the existence of risk-seeking economic strategies, put safeguards in place to prevent them, and plan for fixes ex ante.