Gradient Banding
To slightly blend a shadow and lower its opacity the further away it gets from the object, you can use the Gradient Tool (G). The problem created by this sometimes, is known as posterization and some very distracting banding between the different gray levels becomes visible.

The samples above were saved as GIF with only 128 colours on purpose, to show the effect. JPG would certainly look much better and smoother but the result of adding noise is the same.
To prevent banding in the first place, only add the gradient when you are working in your final colour space. Do not convert from RGB to CMYK or any other colour space with an artificial gradient. Furthermore, if possible, work in 16 bit mode.
Updated: November 8, 2005 (tested with PS CS2)