so, for anyone else who has ever pondered these large life questions, my knowledgable friend Kurt filled me in on the answer:
Rainbows happen only if you are at a particular spot bettwen water vapour and the sun, kind of how the shiny side of a cd reflects a rainbow only in a line across the cd and not the thing when you hold it at an angle.

the whole cd is able to make a rainbow (like the water fall) but the rainbow depends on what angle you look from.
The droplets in a waterfall all refect the light, but if you need to be at a cetain angle for a rainbow to show up.
The reflected light has slightly different angles into your eye (changed by the water drops), the different angles depend on what colour with blue the shortest and red the longest.
wikipedia says it best. (http://en.wikipedia.org/wiki/Rainbow)
"A rainbow does not actually exist at a particular location in the sky. Its apparent position depends on the observer's location and the position of the sun. All raindrops refract and reflect the sunlight in the same way, but only the light from some raindrops reaches the observer's eye. This light is what constitutes the rainbow for that observer."
so you are kinda right, rainbows are happeneing inside every rain drop, they all reflect the colours. but the rainbow you see depends on where you look from.
You look at all the the drops at the same time, so they all each send you a bit of the rainbow, like the pixles on your screen. but only some of the drops are in the right spot for you to see the rainbow.
hope the makes sense. tricky but

I love rainbows :)
cheers
Kurt
Wikipedia: Rainbows!!
thankyou Kurt!!