I see no problem with the Observer pattern in this instance. I use it my own games to notify the underlying systems such as sound, music and statistics logging.
I do not know if it is a good idea to let the physics depend on entities being Observable though, because in order for the entities to register the state change they have to perform some physics calculation. I fear that this might lead to having half of the physics code stuck inside an Observable, and the other half stuck inside an Observer, and I am not sure that is an ideal situation.
I suggest (for the physics only) that you update the model from outside the model. Still, make it Observable for the things not directly related to it, but for core functionality like the physics in a pong game, I really would not do it.
Side note: If you are having fun with design patterns consider the Command pattern for your simple games. I know it is a little bit of a hassle, but it allows for great replay-functionality as well as aids AI development.
Side note two: Have you seen this excellent free e-book