It was both a demonstration of his illusionary powers and his character from the original pulp novels and comics, as well as a clever injoke.
The Shadow was always (ALWAYS) drawn with having a large, hooked, vulture-like nose. It was a trademark of his character, very much like Batman's pointed ears on his cowl. It was just somethnig iconic about the character which was always there.
Even to this day, with modern comics retelling the Shadow stories with new art and writing, he still has a large, hooked nose.
The other reason though, the demonstration of his powers, is that the Shadow as a character would create an illusion of his face being a different shape to throw off criminals and the police.
The third and final reason though is that Alec Baldwin's nose is clearly not as large as the Shadow's is, so they used a prosthetic. I think the idea behind it though was that they made it into something of a joke, having the Shadow have the nose and Cranston Lamont not have it, since as I've said, Baldwin didn't have a large nose.
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