if it has chipped the chrome on the head tube around the top cup, there might be some ovalizing of your head tube going on, or the very early warning signs of impending headtube damage...if it's just the chrome flaking off the headset cup itself, then you will need to definitely replace the headset.

i'm sure you already know this, but just in case and because i haven't seen anyone else explain it, this is how you adjust a threadless headset (a better explanation can probably be found in the mechanics forum in the barnett's manuals):
loosen the stem bolts, tighten the top cap to where it feels tight, but the bearings don't bind, then tighten up the stem bolts to lock in the adjustment. make sure the stem bolts are nice and tight and you should be all set.

tange makes a fairly good 1" threadless headset. you can get them through momovelo, located in beautiful downtown berkeley...AND you'd get to talk to kai, who is really one of the raddest people in berkeley to talk bikes with.

drop me a PM when you're gonna have some free time in SF. maybe we could hang out sometime this week. i just have to know far enough in advance to plan around BART's "commute times."