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So I install two Windows 7 VMs through VMware fusion 4. The desktop resizes very nicely in the first: Windows senses the resizing and uses smaller icons.

In the second VM Windows simply magnifies its desktop to a rather ugly one: the desktop uses more real estate, but it's just a magnified image of a low-resolution desktop.

I'm not aware that I have changed any setting related to the desktop. How can one intentionally get the former behavior?

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Sounds like you might not have VMware Tools installed in the second VM. Do you see the VMware Tools icon in the taskbar tray?

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If not, you can select "Install VMware Tools" from the "Virtual Machine" menu (mine says "Reinstall" as I already have it installed)

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