The Karatsuba algorithm reduces the time complexity of multiplying two n-digit numbers from the conventional O(n^2) to O(n^1.585). It does this by dividing the numbers into halves at each recursive step and performing only three multiplications of the halves rather than the four required by the basic multiplication algorithm. This reduction in the number of multiplications means the overall time complexity improves to O(n^1.584...) which is superior to O(n^2).