Yep, they merge. This specific file behaves differently then the rest. The rest of core files are whole different matter though. Whole file system seems a big freaking mess where each file allows or requires different things then the rest. There simply is no consistency.
For example, when I tried to edit Lethal I, II and III myself I had to do it in core file. Any other attempt resulted in new abilities to merge with the old ones. Whole system needs rework and I guarantee you that there would be at least 3x more mods and modders if it got fixed.
I have numerous examples that could be used to improve this system. Heck, JA2 community came with vastly superior mod system that allows for easy file hierarchy control and some compatibility among mods, at least to the point where you don't have to delete one in order to use another. Not to mention that it made it way easier to maintain mods against game updates and you knew exactly which file was red and which wasn't. And the system isn't really that complicated either, at least for a modder or programmer.
Right now, I have to make a change, play the game and come to a point where I can finally see if the game actually red the freaking change and if it merged it or overwritten old values. It's bad, period.
If someone thought that it would be good idea where you just need to add few xml lines to add new items, they were wrong, very wrong. It may be convenient to add stuff, yes, but it completely breaks CHANGING existing stuff and makes everything inconsistent. What is wrong with copy/pasting existing file and adding new lines to it? In today computers having few 1000 lines of xml code means nothing if you keep consistency and order of the files and make it easy for modders to manage it all. Just simple overriding core files with ones with the same name in the mod folder would go a long way, but the system used in JA2 is vastly superior to even that one and I just can't recommend it enough.
