During Drosophila eye development, Hedgehog (Hh) protein secreted by maturing photoreceptors directs a wave of differentiation that sweeps anteriorly across the retinal primordium. The crest of this wave is marked by the morphogenetic furrow, a visible indentation that demarcates the boundary between developing photoreceptors located posteriorly and undifferentiated cells located anteriorly. Here, we present evidence that Hh controls progression of the furrow by inducing the expression of two downstream signals. The first signal, Decapentaplegic (Dpp), acts at long range on undifferentiated cells anterior to the furrow, causing them to enter a 'pre-proneural' state marked by upregulated expression of the transcription factor Hairy. Acquisition of the pre-proneural state appears essential for all prospective retinal cells to enter the proneural pathway and differentiate as photoreceptors. The second signal, presently unknown, acts at short range and is transduced via activation of the Serine-Threonine kinase Raf. Activation of Raf is both necessary and sufficient to cause pre-proneural cells to become proneural, a transition marked by downregulation of Hairy and upregulation of the proneural activator, Atonal (Ato), which initiates differentiation of the R8 photoreceptor. The R8 photoreceptor then organizes the recruitment of the remaining photoreceptors (R1-R7) through additional rounds of Raf activation in neighboring pre-proneural cells. Finally, we show that Dpp signaling is not essential for establishing either the pre-proneural or proneural states, or for progression of the furrow. Instead, Dpp signaling appears to increase the rate of furrow progression by accelerating the transition to the pre-proneural state. In the abnormal situation in which Dpp signaling is blocked, Hh signaling can induce undifferentiated cells to become pre-proneural but does so less efficiently than Dpp, resulting in a retarded rate of furrow progression and the formation of a rudimentary eye.