Along the drab corridors of the Pentagon and the Federal Trade Commission, and in the plush offices of several Washington law firms, a quiet drama is now playing out that could reshape the contours of American capitalism.

The lawyers and regulators are arguing over a proposal by Boeing Co. to purchase its arch rival in the aerospace business, McDonnell Douglas Corp., for $14 billion. The combined firm would have 200,000 employees and annual sales of nearly $50 billion, roughly the equivalent of the economy of New Zealand. More significant, the new Boeing would become the unchallenged colossus in the world of civil and military aviation.

The merger would leave Boeing one of only two producers of large commercial jets in the world, accounting for roughly two-thirds of global sales. Its only full-line competitor would be the European consortium Airbus Industrie.

Boeing also would become one of two prime contractors for all the Pentagon's jet fighters, military transports and surveillance planes; the other would be Lockheed Martin Corp. of Bethesda, itself the product of a recent mega-merger. It would be NASA's sole prime contractor for a consolidated space station program and, in partnership with Lockheed, for the space shuttle.

A generation ago, government officials would have rejected such a merger out of hand as a clear violation of the antitrust laws. The belief was that by reducing markets to only two players, such a merger would so reduce competition that consumers would be forced to pay more for airline tickets and taxpayers would be forced to pay more for jet fighters and space vehicles.

But Boeing and McDonnell Douglas argue that in this case, those risks are minimal -- and more than offset by the demands of a global marketplace that requires firms to be bigger and more efficient to survive.

In the coming months, the FTC will have to chose between these views and decide whether to let the merger proceed or to challenge it in court. The debate will be waged in the dry language of antitrust law and microeconomics. But it will determine government policy on an issue that affects millions of Americans personally and directly -- the wave of corporate mega-mergers that, in industry after industry, is reducing competition to a handful of large firms.

When Boeing and McDonnell Douglas first announced their merger plan on a crisp Sunday last December, nary an eyebrow was raised. Pentagon officials, anxious to shrink the size of the military-industrial complex following the end of the Cold War, had quietly encouraged the collaboration. And editorialists and industry analysts called it a dream deal, just the thing to ensure continued American dominance in aerospace. Even competitors and airline customers said they saw no problems with the deal.

But in the months since, there have been some second thoughts.

Consumer advocate Ralph Nader wondered aloud that if Boeing were allowed to buy McDonnell Douglas, what principle would prevent General Motors Corp. from buying Chrysler Corp., or Microsoft Corp. from buying Apple Computer Inc.?

Top Pentagon procurement officials, who initially encouraged the defense industry merger trend, acknowledged that the process of consolidation may have gone far enough.

And in Europe, the chief antitrust official of the European Union declared the merger "very problematic" and threatened to fine Boeing $4 billion if it were consummated.

The first review will come from Chairman Robert Pitofsky and his four colleagues on the FTC. Pitofsky, the former dean of the Georgetown University Law Center and the author of a leading textbook on antitrust law, has told associates that he expects the Boeing case to be the most important of his tenure. And he has assembled a team of agency insiders and outside experts to conduct the review and, if necessary, carry the legal fight all the way to the U.S. Supreme Court.

What follows is a review of the issues raised by the Boeing-McDonnell Douglas merger, drawing on conversations with dozens of antitrust experts, economists, government officials and aerospace industry executives. A Natural Duopoly?

Traditionally, antitrust regulators have viewed mergers that reduce competition to two firms (duopolies) with almost as much suspicion as markets with one firm (monopolies). The concern is that with only two, it will be too easy for the companies to settle into a live-and-let-live arrangement -- one in which they can raise prices in tandem, informally divide the market into "your customers" and "my customers," and put off the expense of developing new technologies.

Indeed, in the months since the proposed merger was announced, the aerospace industry already has begun to behave like this sort of cozy, anticompetitive market:

In January Boeing announced that it would not proceed with development of new 500- and 600-seat versions of the 747 that had been announced with great fanfare the year before. The development would have cost at least $7 billion.

Boeing has won agreements from both American Airlines Inc. and Delta Air Lines Inc. that they will buy only Boeing, and just this month Continental Airlines Inc. announced it is considering a similar arrangement. In return for guaranteed discounts and favorable delivery terms, the airlines have agreed to not even consider competitive bids from Airbus for 20 years.

In response to a surge in new orders and tight capacity, prices for commercial jets have risen nearly 5 percent in the past year after years of heavy discounting, the government reported.

More broadly, the history of duopoly markets is that well-matched competitors almost never get into wars over prices or innovation. The reason is simple: They both usually come out losers if they do.

If Airbus, for example, were to cut prices by 10 percent, Boeing would almost certainly match the discount. And as a result, neither side would gain new customers but each would suffer a cut in revenue and profit. Knowing that in advance, neither firm even tries.

By a similar logic, duopolists are also loath to take on the risk and expense of developing new products when they know the other firm, with just as much know-how and money at its disposal, will simply match it, leaving market shares unchanged.

According to Michael Spence, dean of the Stanford University Business School, this risk of a live-and-let-live competition is even higher in markets such as aerospace, where the barriers to new firms joining the competition are high.

After all, it took Airbus 20 years and billions of dollars in government subsidies to finally break even -- a pretty steep entry fee. And even if a new firm were to invest the time and money, it would still confront the customers' strong preference to buy from existing suppliers with proven safety records and planes that use the same cockpits and spare parts and training manuals that they already have.

But executives from Boeing and McDonnell Douglas argue that today's aerospace industry has other characteristics that not only justify a merger, they almost require it.

In the market for commercial jets, they argue, Boeing and Airbus already have reduced McDonnell Douglas to a failing competitor that won only 3 percent of new airplane orders last year and has little prospect of launching a new airplane again. As a result, the merger would simply confirm the reality of the duopoly that the marketplace itself has already demanded.

And in military and space markets, they point out that industry consolidation has been actively encouraged by the Clinton administration, which calculates that the cost of maintaining competition in half-empty factories and underutilized research labs is simply unaffordable.

In effect, industry executives and a number of economists argue that the aerospace industry today has developed into a "natural" duopoly. Whether developing weapons systems or commercial jets, the upfront costs of research, development and computerized precision tools are now so enormous -- and the total demand for products so limited -- that there is room for only two companies to operate and make a profit. Having three or more companies could lead to ruinous competition that could leave all companies financially weak and technologically backward.

"The question is not whether, in theory, two competitors is enough," said Richard Schmalensee, an economist at the Massachusetts Institute of Technology who studies the structure of industries. "The question is whether, in real life, we have a choice. Sure, having a healthy third player in these markets would increase competition. But is that a realistic probability here? The fact is there just isn't enough money to support three players."

The idea that there is an "optimal" number of suppliers in any market is not exactly new. Governments in Europe and Japan have used a similar logic to justify government subsidies and trade protections of one or two "national champions" in key industries. During the decades after World War II, these arrangements produced wonderful results for those economies. But in recent years, their economic growth has slowed to a crawl and officials from Paris to Tokyo are now looking to make their economies more flexible, innovative, open and entrepreneurial -- in other words, more American.

What these foreigners have discovered is that the efficiency that comes with size is only one ingredient in the formula for economic success -- and maybe not even the most important one. For while bigger companies, theoretically, may be able to produce goods and services at a lower cost, experience shows them to be less skillful in coming up with breakthrough innovations and new technologies that lead to new products or new ways of producing old products. And it is those innovations and technologies that in the long run are the real source of economic growth, higher incomes and rising standards of living.

"One of the reasons our economy has grown faster than those of other countries is that we had strong antitrust laws," explains Mancur Olsen, a professor at the University of Maryland who has studied the sources of economic growth. "It turns out that national monopolies and duopolies tend to be sources for inefficiency in the long run for a very important reason: They discourage innovation." Is Douglas's Demise Inevitable?

The demise of Douglas Aircraft Co. as an independent maker of commercial aircraft may have begun with a phone call from Stockholm in March 1995.

Jan Sternber, chairman of Scandinavian Airlines System and one of Douglas's most loyal customers, had stunning news. SAS's internal evaluating committee had recommended the purchase of 50 of Douglas's proposed new 100-seat MD-95 jetliners for $20 million each. But the SAS board of directors was unwilling to commit to an order that large for the brand new plane, particularly from a company whose survival was beginning to be questioned by many in the industry.

Instead, Sternber said that SAS would order 35 of a new version of Boeing's venerable 737 at about $19 million per plane, a steep discount from Boeing's list price. "It was clear that Boeing's strategy was to prevent Douglas from ever launching the MD-95," recalled one salesman involved in the competition.

Launching the MD-95 had been central to Douglas's strategy to return to the top ranks of commercial aerospace. Boeing had dealt the first blow to Douglas 40 years ago with the introduction of its revolutionary 707, which eventually outsold the DC-8 in the glamorous competition for the first successful jetliner. And in the 1970s and '80s, Douglas had seen almost a 1-to-1 relationship between its declining share of the aircraft market and the rising share for Airbus, the European consortium.

Now, with airlines identifying the 100-seat jet as the top priority for the future, McDonnell Douglas had latched onto the MD-95 as its last hope for getting back into the commercial airplane market. But with the SAS decision, other major airlines and leasing companies began to publicly question Douglas's viability. And one by one through 1995 and 1996, they began to opt for steeply discounted Boeing or Airbus planes rather than the MD-95.

In desperation, Douglas finally signed a $1 billion order from airline upstart ValuJet Airlines for the first 50 of the new MD-95s. But within months, the crash of a ValuJet plane in the Florida Everglades killed all 110 people on board and hopes for a quick and certain launch of Douglas's new jet.

Executives at Boeing and McDonnell Douglas point to this slide as proof that Douglas is no longer competitive in the market for commercial jets. As a result, the companies argue, the merger could not possibly violate the antitrust law's stricture against transactions that "substantially lessen competition."

"Douglas is a non-factor," agreed Ed Greenslet, publisher of Airline Monitor, an industry newsletter. "They've eroded too far to be a viable alternative."

But that was not the line taken by McDonnell Douglas executives as recently as last November. In a conference call with industry analysts, company Chairman Harry Stonecipher said Douglas would become a niche player and could still earn a nice profit making small and mid-sized jets. And with customers now facing three-year waits from Boeing and Airbus, Stonecipher said Douglas could expect significant spillover business from airlines desperate for new planes.

"We can sell 50 to 100 planes a year and have a very nice business," Stonecipher said back then, before the merger was announced.

In fact, last year Douglas reported a profit of $101 million on $3.3 billion of commercial sales. And with a backlog of orders valued at $7 billion, many industry analysts predicted that an independent Douglas could remain in business for at least another five years. In addition, even industry analysts skeptical of Douglas's future in commercial aircraft acknowledge that unforeseen events -- a big Chinese order for the MD-95, for example, or another plane crash involving a faulty Boeing 737 rudder -- could easily put the company back in the running.

It is exactly because of such possibilities that antitrust officials and federal judges have been reluctant to allow a merger solely on the basis of speculation about the eventual demise of one of the merging companies.

"There is nothing in the antitrust law that says Boeing cannot or should not wind up as the only airplane maker in America," said Steven Salop, an antitrust expert at Georgetown Law Center. "What it does say, however, is that Boeing shouldn't get there by buying up the competition."

Preventing Boeing from buying up the competition, however, carries other risks, FTC officials acknowledge. Within the industry it is widely believed that if it cannot find a U.S. partner, McDonnell Douglas will seek out an Asian partner for its struggling commercial airplane division. And they warn that this combination -- of U.S. technology with Asian capital and labor -- would hasten the arrival of a new "Asian Airbus," which would almost certainly threaten sales and jobs and profit at Boeing.

This is not merely a fanciful possibility. Five years ago, a cash-strapped McDonnell Douglas agreed to sell a 40 percent interest in its commercial airplane operations to a Taiwanese firm for $2 billion. The deal fell through because of financing problems and political opposition on both sides of the Pacific. But just in the last year, Samsung Corp. of South Korea and Aviation Industries of China have both made clear they, too, were looking for an aerospace acquisition. For either company, Douglas would clearly be an attractive partner.

The prospect of an Asian Airbus clearly worries American policymakers.

"From a national point of view, it is preferable to have a single producer earning generous profits competing with a subsidized foreign supplier," said Laura D'Andrea Tyson, who recently served as President Clinton's top economic adviser. "The U.S. economy is better off even if consumers of airplane seats are somewhat worse off."

Robert Paulson, a consultant at McKinsey & Co. specializing in aerospace, puts it more bluntly: "This is not about Boeing versus Douglas or Boeing versus Airbus. This is about the U.S. economy versus the European economy versus the Asian economy. That's what the government should be worrying about." The Pentagon Weighs In

The Pentagon has made no secret of its support for the Boeing-McDonnell Douglas merger. Even before the merger was announced, Air Force officials had telephoned executives of both companies to urge that they consider some sort of collaboration -- one that would combine McDonnell Douglas's expertise in building fighter aircraft with Boeing's superior skills at designing and developing complex new systems. The marriage was particularly appealing at a time when the Pentagon is moving to select a single contractor to build its next generation Joint Strike Fighter, the most costly weapons program ever.

The merger also would bolster the Clinton administration's efforts to reduce the price of weapons systems by combining defense factories, engineering teams and accounting departments that have been operating well below capacity since the end of the Cold War. Four years after it began, that consolidation has now largely run its course, leaving one or two suppliers remaining in most categories of weapons systems.

Two companies have emerged as the dominant survivors of the Pentagon shakeout -- the proposed new Boeing and the recently merged Lockheed Martin. In the last 18 months, one or the other has won almost every major Pentagon and NASA contract. And Pentagon planning documents obtained by The Washington Post show that, over the next 20 years, Boeing or Lockheed Martin will act as prime contractor on approximately 60 percent, or $360 billion, of the $600 billion to be spent on major weapons procurement {See chart at lower left}.

"I am happy with what's happened in the restructuring of the industry," said Paul Kaminski, the Pentagon's outgoing acquisitions chief. "We will be better served by two or three robust, healthy primes competing than by five or six unhealthy primes."

But defense experts such as Jacques Gansler worry that consolidation may erode the technological edge that has been the critical source of American military superiority since the days of World War II.

"When you look at the history of military technology, it's the third and fourth guy who comes up with the breakthrough," said F.M. Sherer, a Harvard economist who has studied the defense industry. "Just having two companies left generating ideas in most of these areas is worrisome."

The Senate Armed Services Committee with similar concerns, has now launched its own review of defense industry consolidation.

"A lot of us feel defense industry competition has helped create innovation and battlefield dominance," Sen. Joseph I. Lieberman (D-Conn.) said at a committee hearing this month. "How do we determine when this {merger trend} has gone too far?"

"In some markets and product areas, maybe it has," replied John Goodman, the Pentagon official charged with evaluating defense mergers. The Political Side of Antitrust

When Congress passed the Sherman Act, the first antitrust law, in 1890, it was motivated partly by a fear that giant corporations would gain too much political power along with their economic dominance. But in recent years, this political rationale for antitrust has been largely ignored, as judges and regulators focused their attentions on technical economic analyses.

One scholar who agitated against such a narrow view of the antitrust laws was the FTC's Pitofsky, then a law professor at Georgetown. The antitrust law, he argued in law review articles and at academic gatherings, embodied a deliberate determination on the part of the country to sacrifice a measure of economic efficiency to prevent undue concentration of economic and political power.

Now, as chairman of the FTC, Pitofsky has his opportunity to revive interest in the political dimensions of antitrust, particularly as it relates to the aerospace industry, where politics and government play a central role.

After all, on the defense and space side of the business, government is pretty much the only customer, able to dictate not only what will be made, but also by whom, at what price and for whom. But unlike customers in other markets, these government customers can be influenced by suppliers such as Boeing through lobbying, grass roots organizing and political contributions.

Executives of both Boeing and McDonnell Douglas, in fact, make no secret that one motivation for the merger with McDonnell Douglas is to have the additional political muscle to go toe to toe with the other giant of the defense business, Lockheed Martin. The merger will give the combined company a special call on congressional delegations from California, Missouri, Texas, Washington, Alabama and Pennsylvania, which have particular influence on military spending committees. And through subcontractors and their employees, they can bring direct influence to bear on virtually every other delegation in Congress.

Even with the increased political influence that will come with the merger, Boeing's chairman promises that his company will still take its cues from government rather than the other way around.

"The Department of Defense and the Congress have enough capability to make their decisions," Boeing Chairman Philip Condit said in a recent interview.

"I don't think it is an influence issue. . . . We'll argue out points and others will make theirs and that's the way it works. There are a whole bunch of companies bigger than ours."

But at least one top NASA official, who spoke only on condition that his name not be used, warned that consolidation will give contractors greater leverage in dealing with his agency.

"The financial and political clout of these merged firms will go beyond anything we've had to deal with so far," he said. "It could be a real case of oh-my-God for us. It wouldn't be a trivial problem."

Even Lockheed Martin Chairman Norman R. Augustine, who served a tour as secretary of the Army, concedes that "as companies grow bigger, they have more ability to try to affect political outcomes. It may be that's part of the price of having a smaller and more efficient in dustry."

Boeing already has used its clout as the country's top exporter to fight congressional budget cutters seeking to trim government export subsidies. At other times, it has pushed for and won tougher restrictions on how much European governments could support the Airbus consortium. And it was able to block U.S. government financing for the sale of American-made jet engines to Russia until Moscow agreed to open its borders to American airplanes as well -- a concession that last week resulted in a $400 million order from Aeroflot, the Russian airline.

"In political matters, these giant companies are becoming much more active, to the point that they have taken on quasi-government powers," reported Sen. Patrick J. Leahy (D-Vt.), a former chairman of the Senate's antitrust subcommittee.

"They have a disproportionate power in American society -- and that worries me, frankly." Staff researcher Richard Drezen contributed to this report. CAPTION: THE COMPANIES

BOEING

McDONNELL DOUGLAS 1996 Sales Commercial

$16.9 billion $3.3 billion Military & space $5.8 billion $10.1 billion Order backlog

$88.0 billion $44.0 billion 1996 R&D expenses $1.2 billion $355.0 million Employees

147,000

64,000 SOURCE: Company reports VYING FOR MARKET SHARE While Boeing's share of the commercial jetliner market has dipped only slightly over the past decade, Airbus has picked up most of McDonnell Douglas's market loss. Percent of commercial jet deliveries Boeing: 60% Airbus: 30% McDonnell Douglas: 10% SOURCE: Teal Group CAPTION: TOP MILITARY PROGRAMS Boeing or Lockheed Martin is prime contractor on about 60 percent of the big new weapons projects. Type of weapon; Prime contractor; Approximate percentage of the cost of top 20 Defense Department investment programs, 1997-2017 Joint Strike Fighter; Boeing, Lockheed Martin in competition for contract; 13.3% F-22; Lockheed Martin and Boeing; 13.2 F/A-18/E and F; Boeing; *10.3 Munitions, missiles; Mostly Boeing, Lockheed Martin, Raytheon; 9.4 New Attack Submarine; General Dynamics, Newport News; 6.8 SC-2 1 (surface combatant ship); Competition between several shipyards; 4.8 V-22; Boeing and Bell Helicopter Textron; 4.4 DDG-51 destroyers; General Dynamics, Litton Industries; 4.3 CVN aircraft carrier; Newport News; 4.2 C-17; Boeing; *4.0 Theater missile defense; Mostly Boeing, Lockheed Martin, Raytheon; 3.7 C-130; Lockheed Martin; 3.2 AFAS/FARV artillery systems; Several armored vehicle companies; 3.0 Military tankers; Boeing or Lockheed Martin; 2.8 RAH-66 Comanche helicopter; Boeing and United Technologies; 2.7 Space launch vehicles; Boeing and Lockheed Martin; 2.5 Tanks; General Dynamics; 2.3 Milstar communications satellites; Lockheed Martin; 1.8 Drones, experimental projects; Mostly Boeing, Lockheed Martin, Raytheon; 1.7 Trident missiles; Mostly Lockheed Martin; 1.6 * Through intended acquisition of McDonnell Douglas SOURCE: Department of Defense, Army planning office CAPTION: ROBERT PITOFSKY CAPTION: The two chief executives, Harry Stonecipher of McDonnell Douglas, at left below, and Philip Condit of Boeing, announced the merger plan in December. CAPTION: Boeing 747 CAPTION: FA-18 CAPTION: JSF