Retinoic acid (RA) stimulated proliferation of both epithelial and mesenchymal cells in cocultures isolated from developing mouse lungs. There was a corresponding increase in epithelial branching activity in organ culture of embryonic lungs exposed to similar doses of RA. Stimulation was maximal with concentrations of 1 microM and progressively decreased with either lower or higher concentrations. However, when lung cell monocultures of isolated epithelial and mesenchymal cells were exposed to RA, the mitogenic effect was observed only in the mesenchymal population. This suggests that RA may not have a direct mitogenic effect on epithelial cells but rather functions indirectly through the mesenchyme. The cellular response to RA was correlated with an increase in the expression of epidermal growth factor receptor (EGFR). Epidermal growth factor (EGF) also stimulated terminal branch formation in the developing lung. Unlike RA, EGF stimulated proliferation in both epithelial cells and mesenchymal cells in monoculture. In comparison, transforming growth factor-alpha, which also binds to the EGFR, elicited no response. We conclude that RA stimulates cell proliferation and branching activity in the developing mouse lung by a mechanism involving epithelial-mesenchymal interactions. The effect is, in part, produced by stimulation of EGFR expression, with the resulting amplification of the cellular response to EGF or other EGFR ligands. In this process the mesenchyme provides a paracrine support to the epithelium, otherwise unresponsive to RA. Further studies identified the mesenchyme as a major source of EGF in the embryonic lung, suggesting that mesenchymal EGF may represent a paracrine factor involved in the epithelial response to RA.