I like to think of a hard drive as a parking lot. Each car (or file) takes up one parking spot (block of data), no matter if it is a van, compact, or a motorcycle. I know it's a bit more complex than that but this gets the point across.
Lets say your local grocery store opens up for the day. The lot is empty. As the first cars pull in they park in the spaces closest to the store and it's all nice and neat. Over time however, the cars get scattered because they pull in (saving data) and back out (deleting data) at different times. What you end up with is a lot that has some cars in the front, some in the back, and a lot of empty spaces in between. The cars parked closest to the store can be walked to quickly, and the ones at the back of the lot takes a few minutes to get to.
What defragging does is backs all of the cars out and moves the one you would want to get to the most towards the front of the store, and moves the lesser used ones behind them thus eliminating the empty spaces in between and making thing work more smoothly.
When you defrag a game folder, it moves all of its files physically next to each other on the hard drive, so it doesn't have to go looking all over the place for that data. Really, to be honest it doesn't make that much of a difference unless your hard drive is all fragmented to begin with. You probably won't even notice a difference.
