Microsoft has an a KB article HOW TO: Author MSDE 2000 Setup Packages by Using Visual Studio .NET that described how to create own Setup. Our company uses this approach and now have problems with applying SQL Server 2000 SP4.
The latest advice from MS - The Setup utilities for new applications must be written to call the MSDE 2000 Setup utility rather than directly consuming the MSDE 2000 merge modules.
More details about disadvanages of using Merge Modules are on page Using SQL Server Desktop Engine Merge Modules