I have noticed that some NPC's don't equip their gear for some reason. For instance, the blacksmith in Stillwater has multiple Stillwater Blades and a really nice shield in his backpack, but when I attack him he tries to fight barehanded. Also, the elves in Qintarra seem to all have armor in their backpacks but none of them are wearing it.

Those elves, at least, should be wearing their armor. I've noticed that after a battle, sometimes the armor will have minor damage (from a presumed critical hit); that can only happen if it was equipped, rather than just in their inventory.