Kids that young probably don't realize what the word may really mean but rather they hear it used over and over especially for certain situations, such as when someone does something stupid, therefore, it must mean someone is stupid. That's probably the line of thinking that's going on. They don't realize that "gay" doesn't mean stupid but rather it means happy, homosexuality, etc... .

Also, when a kid is insulted with such a word they don't like it as that can separate them from the crowd. So to be part of the crowd, then they can say it and be no longer seen as an outcast.

But one major reason despite the first two outlined is that nobody is there to tell them otherwise. If you as the parent don't tell them otherwise, then how are they to know when nobody else corrects them? However, if you do tell them otherwise yet the other kids aren't told, then they're stuck at a fork: either they obey you at school possibly leading to being an outcast or they disobey and don't risk being an outcast. If they do obey, then they may tell the others what you have told them, which is going against the popular view. As there usually is one or more dominant kids, then your kid would have to confront the dominant one(s).

However, there is now one problem to you telling the kid otherwise: what does the teacher do? If the teacher does not scold the kid, then to the kid, it must be corre... but wait... now you're saying something completely different.... who is correct? Do you tell the kid that the teacher is wrong or what do you do? Remember, kids that young don't have the same capacity of reasoning and understanding as we do, so what is told to them tends to be more factual or something that they'd have to obey rather than seeing that it is open to reason. So if you tell the kid that the teacher is wrong, then does that also apply for other things that the teacher says or does? To us it's obvious that it doesn't but to the kid, is it also as obvious? Absolutely not.