The tyrosine phosphatase Shp2 is recruited into tyrosine-kinase signalling pathways through binding of its two amino-terminal SH2 domains to specific phosphotyrosine motifs, concurrent with its re-localization and stimulation of phosphatase activity. Shp2 can potentiate signalling through the MAP-kinase pathway and is required during early mouse development for gastrulation. Chimaeric analysis can identify, by study of phenotypically normal embryos, tissues that tolerate mutant cells (and therefore do not require the mutated gene) or lack mutant cells (and presumably require the mutated gene during their developmental history). We therefore generated chimaeric mouse embryos to explore the cellular requirements for Shp2. This analysis revealed an obligatory role for Shp2 during outgrowth of the limb. Shp2 is specifically required in mesenchyme cells of the progress zone (PZ), directly beneath the distal ectoderm of the limb bud. Comparison of Ptpn11 (encoding Shp2)-mutant and Fgfr1 (encoding fibroblast growth factor receptor-1)-mutant chimaeric limbs indicated that in both cases mutant cells fail to contribute to the PZ of phenotypically normal chimaeras, leading to the hypothesis that a signal transduction pathway, initiated by Fgfr1 and acting through Shp2, is essential within PZ cells. Rather than integrating proliferative signals, Shp2 probably exerts its effects on limb development by influencing cell shape, movement or adhesion. Furthermore, the branchial arches, which also use Fgfs during bud outgrowth, similarly require Shp2. Thus, Shp2 regulates phosphotyrosine-signalling events during the complex ectodermal-mesenchymal interactions that regulate mammalian budding morphogenesis.