The influence of mesenchymal components on epithelial cell differentiation in fetal lung has mostly been studied in vitro. Here, the relationship of direct epithelial - mesenchymal cell interactions and of matrix changes beneath epithelial cells to the development of Type 2 and Type 1 epithelium is examined in vivo. In late gestation, as epithelial division slows, these cells come in close apposition to fibroblasts. In some places extracellular filaments connect these different cell types, often bridging the basal lamina. In other regions, direct cell-cell contact is made at membrane structures resembling gap junctions which connect fibroblasts to the cuboidal epithelium which develops characteristics of Type 2 cells. After day 20, as endothelial cell proliferation increases, epithelial cells lying directly over the endothelium do not contact fibroblasts. These cells lose lamellar bodies as they flatten out to become Type 1 cells lying on a fused basal lamina made by epithelium and endothelium. The results provide in vivo evidence that Type 2 cell morphology and function is influenced by direct contact with underlying fibroblasts and collagen fibrils. Differentiation to Type 1 epithelium appears to be modulated by capillary growth, either through loss of epithelial contact with the fibroblast and its products, or through an effect of an endothelial matrix component.