It's definitely a conundrum, because not only do small children lack knowledge of traffic laws, they also lack the mental capacity (attention span, depth perception, closing speed estimation) to execute safe driving even if they knew the laws. They also usually lack of good bike control, and ride at low speeds. So it does make some sense to initially teach them to ride as pedestrians. But in our culture, there are not many sources of knowledge of how to move beyond that style as they grow into teenagers. People naturally retain what they learned as kids, especially if no new knowledge to the contrary ever reaches them.
I had a similar incident a few months ago. There is a park near our house that has a stretch of pavement along the river large enough for cars to use, although it is not a named street, and traffic volume is low and slow because of so many other users. It has a white lane on one side, and we have encouraged our boys (7 and 9) to ride in that "shoulder" line. So a few months ago we are out for a family activity in our car, and encounter a cyclist on a narrow country road. He is a foot or so to the left of the white line, which was fine because the shoulder was only about 6" wide. After I slowed and passed him safely, my 7-year-old said that he should have been behind the line. When I asked him why in the world he would say that, he reminded me of our rule on this road in the park, and it made sense to me that he would generalize from that. It reminded me of the need to gradually give them more subtle knowledge about riding practices, as they become ready, which I tried to start doing right then.