I had delightful news today, Dienes finished the NPC extention to this mod.
HIGHLY RECOMMENDED: http://skyrim.nexusmods.com/mods/34792
(My mod applies the improved formula to yourself, his mod applies it to everyone else. You should install both.)

I spent so much time with this. It is a problem lots of people have with the game, and I've made it work so well. So please, please, please endorse. I poured my heart into this!

"I think the [vanilla] damage reduction formula is too bad, and the later game was nearly broken by that."
This is from a forum post I found. I agree entirely.

IN VANILLA SKYRIM, the formula for damage reduction is as follows:
<%dmgReduction>=(<ArmorRating>+100)*.0012

This is silly. This means that as your armor increases, your %dmgReduction rises with a linear scale and, worst of all, your effective durability (The amount of damage you can take) will rise exponentially. Which means (vanilla calculated values):
A player with: 0armor and 100hp can take 114 damage
A player with: 300 armor and 100hp can take 192 damage
A player with: 600 armor and 100hp can take 625 damage
Note that from 300 to 600 armor, you have 2x more armor, and over 5x more extra effective hp.


USING MY FORMULA, the formula for damage reduction is as follows:
<%dmgReduction>=<ArmorRating/2> / (<ArmorRating/2> + 100)

This is good. This means that as your armor increases, your effective durability (The amount of damage you can take) rises with a linear scale. Which means (difficulty1 calculated values):
A player with: 0armor and 100hp can take 100 damage
A player with: 300 armor and 100hp can take 250 damage
A player with: 600 armor and 100hp can take 400 damage
Note that from 300 to 600 armor, you have 2x more armor, and 2x more extra effective hp.
For every additional 300 armor, you get 150 more extra effective hp (as long as you have 100 base hp).


Have any questions? Good, I like to explain how this all works. There is a FAQ section below you can refer to, or you can post a comment or send me a message and I'll get back to you. Also, there is an excel file with graphs about all this in the "Extra" folder of the archive if you want to take a look at it.

The mod also removes the armor cap. But you needn't worry! With the formula, it is impossible to reach 100%dmgResist.. unless you have exactly infinity armor, of course >=)

Do inform me with any troubles! I've tried every way to break my code so it would work improperly, and it hasn't yet. =) However, if you do run into any problems, please tell me exactly how it happened and I'll do my best to recreate it myself. And fix it, of course.

>>I am supporting this mod again as my computer is restored! I'm glad you guys like it so much. =)<<

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**Important**
Install:
1) Merge the data folder from the zip file with your Skyrim\data folder.
2) Be sure that this mod is loaded after other armor related mods; particularly DeadlyCombat.
3) Take off all armor items and turn off all armor-related spells until you reach 0 armor. Then open the console (in game, press ~) and type "set initiateArmorFormula to 1".

How to use:
After you've installed it, it will work on its own.

If you want it to notify you of your stats every time your armor changes, then type "set notifyingArmorFormula to 1" into the console.
If you no longer want it to notify you, then type "set notifyingArmorFormula to 0" into the console.

If you ever need to reinitiate the mod (because you didn't do it right the first time or some such) then you will need to take off all armor items and turn off all armor-related spells until you reach 0 armor. Then type "set initiateArmorFormula to 1" into the console.

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FAQ
Q:How often must I initiate the mod?
A:Once per character.



Q:Why am I starting with negative armor?
A:Players start with -100 armor value in order to counteract the 100 hidden armor given to them by skyrim.



Q:I don't get it.. does your mod make armor better or worse?
A:Neither. Armor is almost as effective as it is in vanilla.
This mod is not meant to make armor better or worse.
This mod is only supposed to change the relationship curve between armor and effective health. That way, getting your armor higher actually means something. And every additional armor is always worth the same amount of additional effective hp, no matter how much armor you have.

(Later on I will add a version with an ini file that lets -you- dictate precisely how effective armor is. However, until SKSE has an update that includes a function for ini files, I am unable to provide you with an ini file. So for now, the effectiveness is at 2; close to vanilla, but with the new curve.)



Q:What happens to the armor rating from my shield and/or spells?
A:The formula updates every second. If you equip your shield or cast an armor spell, it will take less than a second to readjust the value.



***MY FAVORITE QUESTION***
Q:Isn't %dmgReduction and effective health almost the exact same thing?
A:No.
-%dmgReduction is the % dmg reduced from incoming dmg.
-Effective health is the amount of damage a character can take.
%dmgReduction is the "derivative" of effective health. If %dmgReduction is linear, effective health is exponential. If %dmgReduction is logarithmic, effective health is linear.
Take a look at the excel graphs in the download archive to see it graphed out clearly.



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Uninstall:
1) Delete Troy1010_ImprovedArmorFormula.esp from your skyrim\data folder.
2) Delete aaImprovedArmorFormula.pex from your skyrim\data\scripts folder.
3) Delete aaImprovedArmorFormula.psc from your skyrim\data\scripts\source folder.
4) Modify your armor rating to it's origonal.
To do so, take off your armor, open the game console (in game, press ~), and type "player.forceav damageresist 0".


*SPECIAL THANKS!*
chrisnic6 - provided a better alternative for counteracting the extra hidden 100 armor.
Dienes - created an extension to this mod to apply it to NPCs.