I am going to reply to each sentence individually for no other reason than that it will amuse me.
Lost Soul: Correct me if I'm wrong, but you are talking about a hypothetical sandbox situation where the characters tried to find out rumors about good loot, correct?
Yep.
In that case, judge the encounter difficulty by what level they are when they go asking around.
That is an intriguing idea. There's some possibility there. Discovering rumours early on in the campaign would provide you with quite the bonus later on. Question: in what way do the players, through their PCs, discover rumours? It seems like it would be a pretty central point of play - I'd almost suggest (reasonably) complex rules about the placement of rumours and how they are discovered. I'm thinking something relating to risk (sages in the wild, magic divining stones guarded by undead) or some other cost (time + GP).
(The reason for the rules would be because it directly impacts the currency of the game.)
The campaign world isn't a set piece, it changes as time goes on.
That's how I like to play these days.
If the players slay the goblins, then perhaps the dragon is slain by someone else, or gives the magic sword to a trusted servant, etc. OR you just let it keep the sword.
That can happen. I am not a huge fan of NPC adventuring parties but I know that some are. I think they can make the campaign world a lot more dynamic. (I try to do this with regular NPCs.)
When the pc's go after it later, they'll be getting better treasure, but that would closely simulate a "higher level monsters give better treasure" style chart. OR you just make the dragon tougher.
I don't follow.
They haven't tangled with it, so they don't know how tough it really is yet.
I don't like where this is going...
All they heard were rumors about it's power.
Yep. That's the information the players have. That's what they base their decisions on. In order for them to make informed decisions, the information they have must be at least somewhat reliable.
And if they know enough info about it that they can estimate it's power level ahead of time, then it could instead have allies which they weren't aware of.
In this specific format of play, the players make decisions about where they want to take the game. They control the pace, the level of risk they are willing to face, and (therefore) the rewards they reap. In order to make decisions they need to have information. If they can't rely on the information they have, then the decisions they make might as well be random - which is to say, they aren't decisions at all.
If they make a decision, there must be consequences to that decision - both good and bad. If the end result of making the choice to - let's say - tackle the dragon last because they want to gain some levels before facing it, and the encounter with the dragon is just as difficult as it would have been earlier, their choice (to power up first) has been taken away.
That's why you don't want to change the power level (the risk) of the dragon, why you don't want to change the loot (the rewards), and why you want to provide the players with reliable rumours.
So when the players decide that they'd like to look for a powerful magic sword, and go after that - as DM you tell them the risks they face, so they cna make a choice, and the consequences of their choice.
"So any rumours in this little town?"
"Well, this one captured goblin says that their leader has a sword that protects him from fire, is covered in frost, and emits a blue-white glow."
"The red dragon in the mountains - who has a small clergy of hot babes who worship him - comes down to the town every full moon and extorts GP and hot babes."
"The moon is waning right now, so about three weeks until the next full moon."
Then the players can decide to do whatever they feel like. "Let's take on the goblins, grab their sword, and use it to kill the ogres, then head south. I don't really feel like taking on a dragon."
P.S. I would like to apologize if any of my posts were offensive or condescending. I can be like a dog with a bone sometimes, and don't always consider what my words may sound like to those on the other end.
No apology necessary!