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Teenager Daniel LaRusso (Ralph Macchio) moves with his mother (Randee Heller) from Newark, New Jersey to Reseda, a neighborhood in the San Fernando Valley region of Los Angeles, California. The family has travelled in search of a new beginning, after the death of Daniel's father. Their new apartment's handyman is a kindly and humble Okinawan immigrant named Mr. Miyagi (Pat Morita).

The last night of summer, Daniel and his new friends from school travel to the beach; a girl named Ali Mills (Elisabeth Shue) catches Daniel's attention. Her ex-boyfriend, Johnny Lawrence (William Zabka), and his friends accost Ali. Daniel attempts to intervene and ultimately fights with Johnny. Although he knows some karate--learned from books and at the YMCA in New Jersey--Daniel is easily defeated by Johnny, who is better trained.

Unwittingly, Daniel has made an enemy of the Cobra Kai karate dojo's best student. The Cobra Kai dojo teaches an unethical, vicious form of martial arts. Johnny and his cronies thereafter torment Daniel at every opportunity. When Daniel retaliates with a prank at a Halloween dance party, he is pursued by Johnny and four of his Cobra Kai associates (dressed in skeleton costumes), who proceed to beat him severely. Johnny ignores his fellow Cobra Kai student Bobby's advice to discontinue the beating. As they're arguing, Mr. Miyagi appears to be scaling the fence behind them. Just as Johnny is about to give Daniel another blow, Mr. Miyagi jumps off the fence and shoves Daniel out of the way. In a surprising display of karate skill, Mr. Miyagi defeats all 5 Cobra Kai titles with surprising ease. Awed, Daniel asks Mr. Miyagi to be his teacher. Mr. Miyagi initially refuses, but then realizes that his intervention will inevitably result in Johnny and his friends taking further revenge on Daniel. He agrees to go with Daniel to the Cobra Kai dojo to see if they can resolve the conflict. Daniel and Mr. Miyagi confront the sensei of the Cobra Kai dojo, John Kreese (Martin Kove), to stop the harassment. However, Kreese, an ex-Special Forces Vietnam Veteran, sneers at the concepts of mercy and restraint, and has indoctrinated his philosophy into his students. Kreese, who fought in Vietnam, appears somewhat bigoted against people with East Asian features (in the 1986 and 1989 sequels , Kreese refers to Mr. Miyagi as a "Slope"). Mr. Miyagi announces that Daniel will enter the “All Valley Karate Tournament�, where Cobra Kai students can fight Daniel on equal terms. Mr. Miyagi also requests a "truce," that the bullying stop while the boy trains. Kreese orders his students to leave Daniel alone, but threatens that if Daniel does not show up for the tournament, the harassment will resume and Miyagi will also become a target.

Mr. Miyagi becomes Daniel's teacher and, slowly, a surrogate father figure. He begins Daniel's training by having him perform laborious chores such as waxing many cars, sanding a wooden floor, painting a fence, and painting the house encircled by the fence. (The chores are Daniel's "payment" to Miyagi for the training.) Eventually, Daniel becomes frustrated, believing that he has learned nothing of karate, whereupon Mr. Miyagi reveals that Daniel has unknowingly been learning defensive blocks, through muscle memory learned by doing the chores.

Daniel then learns that Mr. Miyagi lost his wife and son in childbirth at Manzanar internment camp while he was serving overseas with the U.S. Army during World War II. The loss of his family and Daniel's loss of his father further strengthens the father-son surrogacy. Daniel also discovers that the outwardly peaceful and serene Mr. Miyagi was a recipient of the Congressional Medal of Honor for heroism against German forces in Europe. A brief flashback by Mr. Miyagi implies that the decoration was for killing many Germans, and details are not otherwise specified.

Through the teaching, Daniel learns not only karate, but also important life lessons, such as the importance of balance, reflected by the belief that martial arts training is as much about training the spirit as the body. Daniel applies the life lessons that Mr. Miyagi has taught him to strengthen his relationship with Ali.

At the tournament, Daniel surprises everyone by reaching the semifinals. Kreese instructs Daniel's semifinal opponent, Cobra Kai student Bobby, to disable Daniel with an illegal attack to the knee. One of the more compassionate Cobra Kai students, Bobby initially resists (also knowing that such a move will disqualify him), but Kreese insists that Bobby put Daniel "out of commission." Bobby reluctantly complies.

With Daniel injured and unable to continue, Mr. Miyagi assures him he has already proven himself. Despondent, Daniel believes that if he does not continue, his tormentors will have gotten the best of him. He therefore persuades Mr. Miyagi to use his special pain suppression technique to allow him to finish the tournament. As Johnny is about to be declared the winner by default, Daniel hobbles into the ring. He manages to earn two quick points at the beginning, but a minor nose injury to Johnny forces Kreese to take a timeout.

As Kreese examines Johnny's nose during the timeout, he orders his student to fight without mercy, telling Johnny to "sweep the leg," targeting Daniel's previous injury. Johnny blanches at the order, knowing that he can win with such an unethical move, but wants to do so fairly in the ring. He reluctantly obeys Kreese and does what is ordered, knocking Daniel to the floor. Though in great pain, Daniel refuses to stay down.

In the final scene, Daniel and Johnny are tied, both one point away from victory. Daniel, barely able to stand, assumes the "Crane Kick" stance, and delivers a blow squarely to Johnny's chin, winning the tournament. Johnny acquires respect for Daniel as a result of Daniel's win. With respect and without malice, Johnny takes the trophy from the emcee and presents it himself to Daniel. "You're alright, Larusso -- great match!"

Meanwhile, for all the adoring crowd and the trophy, the greatest reward for Daniel is the sight of Mr. Miyagi's face beaming with pride at his student's triumph.

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