I first used the relation given:
$A_i=A_{i-1}\cup \{A_{i-1}\}$
$\implies A_1=A_0 \cup \{\varnothing\}$
$\therefore \space A_2=A_1 \cup \{A_1\}=\varnothing \cup \{\varnothing\}\cup \{\varnothing \cup\ \{\varnothing\}\}$
$\therefore \space A_3=A_2 \cup \{A_2\}=\varnothing \cup \{\varnothing\}\cup \{\varnothing \cup\ \{\varnothing\}\}\cup \{\varnothing \cup \{\varnothing\}\cup \{\varnothing \cup\ \{\varnothing\}\}\}$
My assumption was the answer is $\{\varnothing\}$. But it was a handwaivy way how I came to this conclusion and comes out to be wrong!
The correct answer to this problem is:
$\{\varnothing,\{\varnothing\},\{\varnothing,\{\varnothing\}\}\}$
Please give me proper and justifiable answer to this question
You're correct all the way. $$A_3=\emptyset \cup \{\emptyset\}\cup \{\emptyset \cup\ \{\emptyset\}\}\cup \{\emptyset \cup \{\emptyset\}\cup \{\emptyset \cup\ \{\emptyset\}\}\}$$ Simplify the first four $\emptyset$'s. $$A_3=\{\emptyset,\{\emptyset\}\}\cup \{\emptyset \cup \{\emptyset\}\cup \{\emptyset \cup\ \{\emptyset\}\}\}$$ Then the next four, $$A_3=\{\emptyset,\{\emptyset\}\}\cup \{\{\emptyset \cup\ \{\emptyset\}\}\}$$ Finally, just collect the elements: $$A_3=\{\emptyset,\{\emptyset\},\{\emptyset \cup\ \{\emptyset\}\}\}$$
EDIT: Just keep in mind that $S\cup\emptyset=S$, for any set $S$.