Normal branching morphogenesis and cytodifferention of the lung require a specific interaction between the epithelial rudiment and pulmonary mesenchyme. Previous studies in the mouse have shown glandular stage pulmonary mesenchyme can elicit a lung-like pattern of branching morphogenesis when grafted onto tracheal epithelium of the same age that has been denuded of its own mesenchyme. We have examined whether are not this pattern of branching is accompanied by changes in epithelial cytodifferentiation. Purified pulmonary mesenchyme was isolated from the distal tips of day 13-14 fetal rat lungs and grafted onto a stretch of tracheal epithelium from which the mesenchyme had been removed. The grafts were cultured on semisolid 0.5% agarose in Waymouth's medium containing 10% serum for 5 days and then for an additional 2 days in the same medium containing 10(-6) M cortisol. Unoperated or operated-ungrafted tracheae and intact lung explants served as controls. Grafting distal tip pulmonary mesenchyme onto the tracheal epithelium induced a pattern of branching identical to that seen in control lung explant cultures, while ungrafted control tracheal cultures formed cystic structures. Light microscopy of the induced tracheal epithelium showed that the constituent cells exhibited a morphology virtually identical to cells in control lung explants. Ultrastructural analysis demonstrated that the induced tracheal epithelial cells contained lamellar inclusion bodies, and the lumina of the induced acinar structures contained tubular myelin figures. Reverse transcription polymerase chain reaction analysis of the induced tracheae revealed the presence of mRNAs for surfactant protein A (SP-A) and SP-B, as well as SP-C, which is a specific marker for type II cell differentiation in the adult rat. Control tracheal cultures contained mRNAs only for SP-A and SP-B. Immunocytochemistry demonstrated that many cells within the induced tracheal epithelium were positive for SP-A and SP-C proteins. Further studies demonstrated that the ability of mesenchyme to induce tracheal epithelium varied within the pulmonary tree, and that the competence of the tracheal epithelium to respond to the influence of distal tip mesenchyme was temporally restricted. Our results demonstrate that pulmonary mesenchyme can act instructively on the tracheal epithelium to induce a program of type II cell differentiation.