All three files differ.
file1 is different.
file2 is different.
file3 is different.
diff3 is also designed to merge changes in two differing files based on a common ancestor file (i.e., when two people have made their own set of changes to the same file). diff3 can find changes between the ancestor and one of the newer files and generate output that adds those differences to the other new file. Unmerged changes occur where both of the newer files differ from each other and at least one of them differs from the ancestor. Changes from the ancestor that are the same in both of the newer files are called merged changes. If all three files differ in the same place, it is called an overlapping change.
This scheme is used on the command line, with the ancestor being file2, the second filename. Comparison is made between file2 and file3, with those differences then applied to file1