[Joe Ross]

For an arm application, I think potentiometers are a better choice then a typical rotary encoder.

They are easier to interface and debug (3 wires to a analog port that you can test with a multi-meter, vs 4 wires to 2 digital inputs that you need to test with an oscilloscope)
They provide absolute angle (typical rotary encoders only give relative position, which is a problem if you start with the arm in an different location)
They are significantly cheaper ($4 at radioshack or $10-15 for a high quality pot from digikey, vs $40 or more for a rotary encoder)
They are available locally
In my experience, they are much more robust then encoders

The main disadvantages of potentiometers are that they are noisy and have less resolution then encoders have never been an issue for us when used on an arm.