We should determine how to handle driverless cars based on their overall safety, not edge cases. If driverless cars have significantly fewer injuries/accidents/etc. per mile driven than human drivers, we should push to expand them. If they only drive better in certain areas, we should geofence them.
If they're safer than human drivers but would hit the guy with the dogs in this case, we should still allow them. The opportunity cost of the other accidents that would've occurred if self-driving cars weren't allowed very much matters. Plus the guy with the dogs shouldn't be stepping out into the street (and the guy with the small dog should be able to maintain control of a small dog).
Also, in a world of self-driving cars, the guy doesn't have to try to get somebody's attention out of fear they won't see the small dog, because self-driving cars don't have the limited visibility issues that a human does.