This model raises an important question (with implications for the real world): if you’re a detective in the kingdom of the gullible king who is at least somewhat aware of the reality of the situation and the distortonary dynamics, and you want to fix the situation (or at least reduce harm), what are your options?
I suspect that is not the first question to ask. In the spirit of Inadequate Equilibria, a better initial question would be, “Can you take advantage of the apparent irrationality of the situation?”, and “What fraction of the population would have to cooperate to change things for the better?” and if there is no clear answer to either, then the situation is not as irrational as it seems, and the artificial optimism is, in fact, the best policy under the circumstances.
It’s not really clear to me what it would mean for a situation to be rational or irrational; Jessica didn’t use either of those words.
If the answers are “no” and “lots”, doesn’t that just mean you’re in a bad Nash equilibrium? You seem to be advising “when caught in a prisoner’s dilemma, optimal play is to defect”, and I feel Jessica is more asking “how do we get out of this prisoner’s dilemma?”
My point, as usual not well articulated, is that the question “how to fix things?” is way down the line. First, the apparent “distortonary dynamics” may only be an appearance of one. The situation described is a common if metastable equilibrium, and it is not to me whether it is “distortionary” or not. So, after the first impulse to “fix” the status quo passes, it’s good to investigate it first. I didn’t mean to suggest one *should* take advantage of the situation, merely to investigate if one *could*. Just like in one of Eliezer’s examples, seeing a single overvalued house does not help you profit on it. And if there is indeed a way to do so, meaning the equilibrium is shallow enough, the next step would be to model the system as it climbs out of the current state and rolls down one of many possible other equilibria. Those other ones may be even worse, but the metric applied to evaluate the current state vs the imaginary ideal state. A few examples:
Most new businesses fail within 3 years, but without new aspired entrepreneurs having a too rosy estimate of their chances for success (cf the Optimism bias mentioned in the OP) there would be a lot fewer new businesses and everyone would be worse off in the long run.
Karl Marx was calling for the freedom of the working class through revolution, but any actual revolution makes things worse for everyone, including the working class, at least in the short to medium run (years to decades). If anything, history showed that incremental evolutionary advances work a lot better.
The discussed Potemkin Villages, in moderation, can be an emotional stimulus for people to try harder. In fact, a lot of the fake statistics in the former Soviet Union served that purpose.