Joker reveals that Batman will have to choose between Harvey and Rachel, because Rachel is on Avenue X and Harvey is on 52nd Street. Batman goes to rescue Rachel, while Gordon goes to rescue Harvey.
We see Harvey in a warehouse and Rachel on a rooftop. They are both tied to oil drums and they can communicate with one another. Back in his cell, Joker tells one of the cops that he wants his phone call. The cop refuses and Joker asks him how many of his friends he has killed. Angrily, the cop tells him that he's killed six of his friends.
Outside, the large man keeps complaining about how his "insides hurt" and suddenly collapses.
Meanwhile, Rachel tells Harvey via the intercom that only one of them is going to make it and that the Joker is going to make their friends choose. Harvey scrambles to find something sharp to cut himself free, but accidentally falls over and knocks over an oil can. Oil spills onto the ground and covers half of his face.
In the cell, Joker continues to bait the cop by telling him that he uses a knife to kill because it's slower and details that some of the cop's friends were cowards. The cop goes to beat him up, while outside the cell, the other cops observe that the large man who has been complaining has some kind of contusion on his stomach.
Somehow, Joker manages to take the cop hostage, and pulls him out of the cell. When they ask him what he wants, he tells them he just wants his phone call. An officer tosses him a cellphone, and when he makes his call, something lights up in the large man's stomach: another phone. The whole office blows up, allowing Joker to escape, with Lau in tow.
Rachel speaks to Harvey over the intercom, and tells him that she will marry him. She is interrupted by Batman busting into the warehouse where Harvey is being held hostage. The Joker lied about who was where, and now Batman has saved Harvey, not Rachel. Rachel begins to speak when the building explodes; Gordon was too late. As the warehouse where Harvey was explodes as well, half of his face catches on fire.
At the scene of the explosion, Gordon realizes that Joker planned for his own arrest all along. We see Batman looking at the rubble of the exploded building where Rachel died, as we hear Rachel's letter to him read in voiceover. In it, she expresses her desire to marry Harvey. We see Alfred reading it and putting it down, unsure of whether to give it to Bruce.
Alfred brings Bruce breakfast, and Bruce asks him if he brought Rachel's death about. "Things were always going to get worse before they got better," says Alfred, suggesting that Rachel always thought that he should do what is best. Bruce then tells Alfred that Rachel was going to wait for him, and that Harvey did not know about their love. Alfred, worried about Bruce's state of mind, grabs Rachel's letter so that Bruce does not read it.
Gordon visits Harvey in the hospital, and apologizes about Rachel. He acknowledges the fact that Harvey is refusing the surgery that the doctor is ordering and will not accept skin grafts. Harvey simply says, "Remember that name you all had for me when I was in Internal Affairs?" and makes Gordon say the name: "Two-Face."
Harvey is furious with Gordon for trusting cops whom he explicitly told him not to trust. He shows Gordon his disfigured face and tells him to leave. On his way out, Gordon runs into Maroni, who tells him he knows where the Joker will be that afternoon.
At a warehouse, Joker collects all the stolen money and has one of his cronies pour gasoline on it. On top of the pile is Lau, whom he is holding hostage. He throws one of the mobster's cigars onto the pile and burns it, saying, "All you care about is money. This town deserves a better class of criminal, and I'm gonna give it to them."
Bruce's accountant goes on television to announce the true identity of Batman. Joker calls in to the show, and says that if Coleman Reese, the accountant, isn't dead in 60 minutes, he will blow up a hospital. Gordon sends his men to evacuate all the nearby hospitals, while also protecting Reese.
A policeman goes to Harvey's hospital room, but when the nurse turns around, it is Joker in disguise. He shoots the policeman, then goes to Harvey and makes a speech to him about joining his forces and becoming a supervillain. "I try to show the schemers how pathetic their attempts to control things really are," Joker says, untying Harvey. He tells Harvey that chaos is fair and puts a gun to his own head. Harvey flips a coin to determine whether or not to shoot Joker.
We see Joker exiting the hospital and pressing a button as it blows up in a huge explosion. He gets in a bus full of patients, which drives away. Gordon gets word that there are 50 passengers missing on a bus that was evacuating the hospital.
A reporter appears on the news in Joker makeup reading a message from the Joker that says that everyone who doesn't want to play "the game" should leave the city, but that it will be hard to leave via the bridges and tunnels.
Detective Wuertz, the cop who had Harvey Dent picked up after Joker was captured, sits at a bar, drinking. Suddenly, Harvey—now Two-Face—appears behind the bar and holds him at gunpoint. He flips a coin to determine Wuertz's fate, then shoots him.
Lucius gets word that someone has broken into the R&D section of Wayne Enterprises, and goes to investigate. Batman is there and has turned all of the cellphones in Gotham into microphones to spy on conversations. "Spying on 30 million people isn't part of my job description," says Lucius, but Batman tells him that he must track down the Joker using this technology. Lucius agrees, but tells him that he will be resigning afterwards, in protest against the surveillance technology. "When you're finished, type in your name," says Batman.
Gordon meets with the mayor and they discuss evacuation strategies. Gordon suspects that the prisoners they put away are involved in Joker's plot, and then tells the mayor that they haven't located Harvey yet.
As Maroni gets in a car, Two-Face is sitting there with a gun. He asks Maroni who picked up Rachel, and he tells him it was Ramirez. Two-Face flips a coin and shoots Maroni's driver, causing an accident.
Joker's villainy is wrapped up in his lawlessness, isolation, and his ability to determine exactly what makes his victim's angriest. When he is being held in the cell while Batman and Gordon go to save Rachel and Harvey, Joker taunts the cop watching him about how he likes to kill his victims. It does not take long for the Joker to get under the cop's skin, which he knows is the best way to gain the upper hand in any situation. Thus, we see that the Joker's talent for criminality stems from his sociopathic disregard for the feelings of others and his tendency to target their emotional vulnerabilities in order to gain power.
The Joker is also defined by his particularly grotesque maneuvers, perhaps best typified by his planting a bomb inside the stomach of a fellow inmate, another paranoid schizophrenic. He is always one step ahead of the authorities with a particularly upsetting and disturbing plot. Not only are his actions scary and unpredictable, but there is often something repulsive about them. Embedded in each of Joker's methods is an allusion to his name, a perverse humor that only he could find funny.
In this section, Bruce suffers a tragic loss when Rachel dies in the explosion Joker staged. While he goes and saves Harvey Dent, Gordon does not make it in time to save Rachel, who dies in a fiery explosion. Bruce takes responsibility for the tragedy, having lost the only person he has ever loved as a result of his refusal to unmask himself. Furthermore, Rachel, frustrated with Bruce's devotion to his superhero alter-ego, chooses Harvey over him anyway. According to her letter, had she lived, Rachel would have abandoned Bruce no matter what.
The Joker continues his reign of chaos when he calls into the television show and threatens to blow up a hospital if no one kills Bruce Wayne's accountant, Coleman Reese. Here, he further disorients the city by redefining morality and creating a city-wide panic. If no one kills one man, many people will die. The ethical action to take would be to kill Coleman Reese in order to save the vulnerable patients at a hospital, but murdering Coleman Reese would also be unethical. This dilemma is a version of the ethical dilemma philosophers call "the trolly problem": is it ever ethical to take one life in order to spare others (for example, by diverting a trolly from a track on which it will kill many people to another track where it will kill one person)? Of course, in this instance, this dilemma is not randomly occurring: it has been staged. Joker, in forcing everyone to play his evil games, creates a completely anarchic moral landscape, in which people must choose between two evils.
In this section, Harvey Dent goes over to the dark side. Dismayed by the betrayal of Gordon's cops, his disfigurement, and the death of the woman he loves, Harvey is twisted by his own rage and disempowerment. Then, when the Joker gets to him, and suggests that he ought to come over to the side of evil once and for all, Harvey makes his full transition into the villain, Two-Face. In this, we see a villain origin story, in which the transition is prompted by the villain's embrace of his own pain and the chaos it creates within him.