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In this paper, we show that the "Merger Paradox" (Salant, Switzer and Reynolds, 1983) is mitigated when capacity constraint is considered. This is because outside firms who do not participate in a merger cannot expand their output beyond their existing capacity, and therefore, Stigler type of free riding is alleviated. When overcapacity is socially costly, it is also shown that a pro-merger fiscal policy may discourage ex ante capacity investment and hence alleviate overcapacity, if capacity building is not too costly. Furthermore, it can be shown that the optimal pro-merger subsidy is always welfare improving when it discourages capacity building.