The otocyst is the epithelial anlage of the membranous labyrinth that interacts with surrounding head mesenchyme tissue during formation of the otic capsule. In vitro studies were performed to gain a better understanding of the role that epithelial-mesenchymal tissue interactions play in development of the otic capsule. Parallel series of otocyst/mesenchyme (O/M) and isolated periotic mesenchyme (M) explants provided morphological and biochemical data. The results indicate that epithelial-mesenchymal tissue interactions control development of both the otic capsule and the perilymphatic spaces. The otocyst induces cartilage differentiation in periotic mesenchyme between embryonic days 11 to 13 and organizes otic capsule morphology between embryonic days 13 to 14 in the mouse embryo. The otocyst exerts a localized repression of chondrogenesis in nearby mesenchyme during perilymphatic space formation on embryonic days 12 to 14.