Application pools are IIS processes. They listen incoming web traffic in their configured ports and handle it accordingly. In SharePoint you can find each web application as w3wp.exe from Task Manager.
An application pool isolates different web sites from each other, and each has it`s own resources. This prevents a web site from crashing when another web site crashes in the common host. As an example we can give memory leaks, when there is a memory leak in a web site this will affect only itself. Because the resources are isolated other web site resources remains available to their owners. Applicatio Pool identities are very improtant specially in SharePoint. They define the security context of application pool worker process. You need to plan before setting these entities, without correct rights there is no way you can make SharePoint work.
Things to remember:
- Isolation of Web Applications
- Individual worker process for each application pool