Circle 3 is saying that's how big the moon would look like if it was actually proportionally sized to the cloud, and actually "in the sky" as opposed to be 238,

Circle 3 is saying that's how big the moon would look like if it was actually proportionally sized to the cloud, and actually "in the sky" as opposed to be 238,000 miles away. 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.