I was confused by that as well. I think it's trying to describe this effect: http://en.wikipedia.org/wiki/Moon_illusion#mediaviewer/File:...
Basically, the argument here is that we judge the size of things in the sky under the assumption that they are in the sky. But the moon is not; it does not follow the perspective rules of things that are actually close to us. The figure is saying that when we see situation 1, our brain assumes situation 3 will hold.