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This joke tickles our funny bone through a classic bit of wordplay, specifically a pun. Puns are a clever type of humor that rely on words having multiple meanings or sounding similar to other words, creating an unexpected twist that makes us smile. In this case, "smile-dragon" plays on the familiar fantasy creature, twisting its name to suggest a happy demeanor. The humor comes from the surprise of hearing a word that sounds like a type of dragon, but with a cheerful, human-like emotion attached.
Dragons in mythology and folklore are typically depicted as fearsome, powerful beasts, often large, scaly, and fire-breathing. Western dragons, for instance, are frequently portrayed as dangerous predators, guarding hoards of treasure and posing a threat to heroes. This joke playfully subverts that intimidating image by imagining a dragon that's, well, just happy. The unexpected contrast (Review) between the fearsome nature of a typical dragon and the idea of a "smile-dragon" is what makes the joke lighthearted and amusing, turning a creature of myth into a source of simple, silly fun.