Fellow student seems to be chasing rainbows. Should I step in?
Which kind of interaction, if any, is ethical and reasonable for me to engage in?


Discuss your concerns with your peer. 


  How are similar problems usually handled in academia? 


Through discussion.


  Are people like my fellow student...left alone to their own
  judgement, 


Largely, yes, but...


  or do co-academics talk them out of seemingly bad ideas? 


...in an ideal world colleagues (who they've discussed their work with) will try to bring them back on track.


  Do people criticize each others' research a lot?


Yes! Constructive criticism is central to the research process (unconstructive criticism is unfortunately common).