ro(Dom) is a dominant allele of rough (ro) that results in reduced eye size due to premature arrest in morphogenetic furrow (MF) progression. We found that the ro(Dom) stop-furrow phenotype was sensitive to the dosage of genes known to affect retinal differentiation, in particular members of the hedgehog (hh) signaling cascade. We demonstrate that ro(Dom) interferes with Hh's ability to induce the retina-specific proneural gene atonal (ato) in the MF and that normal eye size can be restored by providing excess Ato protein. We used ro(Dom) as a sensitive genetic background in which to identify mutations that affect hh signal transduction or regulation of ato expression. In addition to mutations in several unknown loci, we recovered multiple alleles of groucho (gro) and Hairless (H). Analysis of their phenotypes in somatic clones suggests that both normally act to restrict neuronal cell fate in the retina, although they control different aspects of ato's complex expression pattern.