The trivial answer is "yes, physical servers are required, if only to host all those virtual servers". But I suspect you're asking "why would anyone pick physical over virtual, or vice-versa".
Funny you should ask. I just agonised about whether to virtualise my colo'ed box, and in the end decided against it. The pros were obvious: it's cheaper, more flexible, someone else looks after the hardware, I get virtualised "console" access rather than having to pay for IP-based KVM (or drive to the colo), and so on.
In the end, I decided to stay physical.
The first hard reason was that I wanted to use a USB device called an Entropy Key to inflate my server's entropy pool. I know that most virtualisation technologies do permit physical (USB) devices to be routed through to a particular VPS, but it's not a standard feature of most virtualisation packages.
The second hard reason was that I wanted a degree of control over who's on my hardware that I can't get with virtualisation. Physical access is always an issue, but my colo's pretty physically secure, has cameras all over the DC floor, and so on: it would be hard even for an employee to access it and leave no trace. If he's simply sitting on the dom0 hardware, he can watch everything my server does, and quite possible leave no footprint. What can I say, I'm paranoid.
The final reason was that I can be very clear about what my constraints are. I know how much bandwidth my discs have, because they're mine, not a supposedly-reserved channel on some over-allocated backplane. Similarly, my memory's mine, I paid for it, and it's all there when my kernel wants it.
I suppose in the end it comes down to control versus convenience. If you prefer the former, stay physical; if you prefer the latter, virtualise.