There are two upgrades for the knife.
1. A female merchant in the main market place of the hidden city. (When you reach the hidden city you follow the woman and her child through the town, you will walk straight through the market, in this market there are TWO sellers not just one. The female seller has a knife upgrade_
2. A side mission in the hidden city. Once you cross the guarded bridge in a disguise (in a main story mission) you will meet a small boy who tells you about his friend who needs help with her father. This gives you a side mission where you have to free the man from a prison cell. Once you free him, he offers you a knife upgrade.