Bob, merge selected on the layers palette merges layers, not paths. To merge paths, you will probably want to use the pathfinder palette. Pathfinder gives you a number of ways to combine or separate objects.
I hope you don't mind my poking fun above. It's just that I got a laugh when I got to the end of your post where you said "Is this a bug?"
If you need more help, we're here.
Rob