Why doesn't the image size reduce when I shrink the container?

If I remember correctly, in this old squarespace editor, the minimum size of the image is the pixel size of the image, dragging the box smaller just crops the image. If you want it smaller than it is currently, you will need to reduce the resolution of the image and then re-upload it.

This is something that has been improved in the new editor on 7.1, there you can set the image to FIT or FILL, set to fit, it will resize and always be smaller than the block size.