What is product category level?
You should choose products belonging to which category when you are adding product. You can classify all products into different categories and then each category can also be classified into 2nd or 3rd level (depends on the number of the levels you confirmed).

Please Note: After setting, the category has to be added to all levels before you add any product.
(Example: If you confirm 3 levels category, you have to add the category to the 3rd level before adding any product.)