Question:

What does a small droplet of water act as?

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For a rainbow to be seen, the sun must be behind the observer, and there must be water droplets (like rain or mist) in the air in front of the observer.
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Solution and Explanation

A small, spherical droplet of water acts as a tiny prism. Just like a glass prism, it refracts the incoming sunlight, disperses it into its spectrum of colors, and then reflects it internally to direct the separated colors towards the observer's eye.
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