The U.S. government was encouraging consolidation in the defense industry as the Cold War ended and there was pressure to rationalize U.S. military spending in the wake of large budget deficits (i.e. the "peace dividend"). Lockheed and Martin-Marietta's merger to form Lockheed Martin is another example.
The battle between McDonnell-Douglas and Lockheed over the medium-size widebody market (DC-10 and L-1011) was devastating for both - it forced Lockheed out of the commercial aircraft market and was crippling to MDD. Airbus's entry into the market with the A300 and Boeing's 767 (with its advantage of type commonality with the narrow-body 757) further fragmented the 200-300 seat widebody market; it was difficult for all with a 4-way battle among the players.
The MD-80 was a good attempt to squeeze additional life out of the 1960's DC-9 airframe design, but intense competition with Boeing's 737 family (and later Airbus's A320) meant that there wasn't a lot of profit to be made - even as MDD sold hundreds each to Delta, American, Continental, TWA, etc.
When MDD was designing the MD-11, cash was short, and they really didn't have the financial resources to design anything more innovative than a DC-10 derivative. Unfortunately, the MD-11 airliner did not initially meet the performance goals that had been promised; moreover, MDD's financial condition likely made some airlines wary of committing to the program. There were questions even during the 1980's about whether McDonnell-Douglas could be a viable competitor in the jet airliner market, given an extremely strong Boeing and a European competitor whose owner-governments were willing to subsidize indefinitely.
The merger was supported by the U.S. government because it fit with their goal of consolidation among defense contractors, as well as preserving at least some of the jobs in MDD's commercial aircraft division in Long Beach - since it looked increasingly likely that MDD would exit the commercial aircraft market. And, for what it's worth, if you want someone to blame for the end of MDD, you can place the blame squarely on the shoulders of those who subsidized Airbus.