In first priority encoder, both 1 & 2 are high, Hence priority is given to 2. Hence output of 1st encoder is 2.
In Mux, input is 1 and 0. Hence output is S0'I0 = 0. But 1 input is given to next priority encoder also.
Hence for next priority encoder inputs are again 1 & 2.
Hence priority is given to 2. And LED 2 will glow.