If they knew the precise location, there would be no penalty to hit. The best that is happening is that the attacker knows approximately where the invisible creature is, limiting it to a 5 foot area.
There are no "5' areas" in AD&D. Eg the standard marching order is 3 people abreast in a 10' corridor, and the suggested scale for miniature purposes is 1 inch square corresponding to 3 1/3 feet (see DMG p 10).
That's the way every edition of D&D has worked. When it's the caster's turn, nobody else gets to do anything without some special ability that allows it to act out of turn.
This is not accurate for AD&D.
Per Gygax's PHB (pp 100-4):
Most spells can be cast during the course of a single melee round, although some - particularly high level ones - require more time. Casting a spell requires certain actions, and if these are interrupted, the spell cannot be cast and is lost from memory. . . .
Many [spell] attacks will happen ner the end of a melee round. This is because the spell requires a relatively lengthy tim to cast, generally longer as spell level increases, so high level spells may take over a full melee round to cast.
And from Gygax's DMG (p 65): When casting a spell
commencement is dictated by initiative determination as with other attack forms, but their culmination is subject to the stated casting time. Both commencement and/or completion can occur simultaneously with missile discharge, magical device attacks, and/or turning undead. Being struck by something during casting will spoil the spell . . .
pell casting during a melee can be a tricky business, for a mere shove at any time can spoil the dweomer! . . . Use the following procedure for spells cast during melee . . .
Attacks directed at spell casters will come on that segment of the round shown on the opponent's or on their own side's initiative die, whichever is applicable. (If the spell caster's side won the initiative with a roll of 5, the attack must come then, not on the opponent's losing roll of 4 or less.) Thus, all such attacks will occur on the 1 st-6th segments of the
round. . . .
Page 66 of the DMG also discusses spell interruption, although via a different mechanic:
uppose side A, which has achieved initiative (action) for the round, has a magic-user engaged in casting a spell. Compare the speed factor of the weapon with the number of segments which the spell will require to cast to determine if the spell or the weapon will be cast/strike first, subtracting the losing die roll on the initiative die roll from the weapon factor and treating negative results as positive. Example: A sword with a factor of 5 (broad or long) is being used by on opponent of a magic-user attempting to cast a fireball spell (3 segment casting time). If the sword-wielding attacker was represented by a losing initiative die roll of 1, the spell will be cast prior to the sword's blow. A 2 will indicate that the spell and the blow are completed simultaneously. A 3-5 will indicate that the blow has a chance of striking (if a successful "to hit" roll is made) before the spell is cast, arriving either as the spell is begun or during the first segment of its casting. Suppose instead that a dagger were being employed. It has a speed factor of only 2, so it will strike prior to spell completion if the initiative roll which lost was 1-4 (the adjusted segment indicator being 1, 0, 1, 2 respectively) and simultaneously if the die score was a 5. If the weapon being employed was a two-handed sword (or any other weapon with a speed factor of 10, or 9 for thut matter) there would be no chance far the reacting side to strike the spell caster prior to completion of the fireball. Note that even though a spell takes but 1 segment to complete, this is 6 seconds, and during that period a reacting attacker might be able to attack the magic-user or other spell caster prior to actual completion of the spell!
I won't try and reconcile/combine pp 65 and 66 in this post (for some discussion, see this thread from two-and-a-half years ago). But those pages do make it clear that, when it comes to spell-casting, action is somewhat simultaneous and even a character whose side lost initiative can still potentially act, and hence interrupt a spell, before the spell is cast.
Turn-by-turn, "stop motion" initiative is a 3E innovation.
I think it goes back to something I've heard [MENTION=42582]pemerton[/MENTION] refer to as a fundamental difference in approach between 2e and other editions that came before. I've never played 2e, but my understanding is that it encourages DMs to directly adjudicate the fiction, whereas in earlier editions the fiction results from applying the resolution mechanics. I bring this up now because you're presenting a fictional scenario here that is precluded by the mechanics as some sort of proof that the mechanics don't work the way they do. According to my understanding of the mechanics, the elf is not within the area of effect precisely because it is undetected.
I think there are some moments in pre-2nd ed AD&D where the fiction has to be "directly adjudicated" - eg yesterday I ran a one-off AD&D game with random dungeon generation from Appendix A, and at one point the PCs used a large iron trunk they had found as a step to climb down into, and back out of, a pit. That was directly adjudicated.
In his Basic rulebook, Moldvay also gives an example of directly adjudicating the fiction even when it means overriding the default mechanics (P B60:
uppose the DM is running a combat that is taking place on a ledge next to an unexplored chasm. One player . . . announced "My character want to jump into the chasm to escape!" There may be a chance that he will fall to a nearby ledge or land in a pool of water at the bottom of the chasm. The DM . . . remembers that an underground river flows through some of the lower dungeon levels, so there might be a pool below. Even so, the character will fall 60', and a normal fall will do 1d6 points of damage per 10' fallen. The character has only 7 hp . . . However, there should always be a chance to do something nearly impossible. . . The DM answers: "Looking down into the chasm, your character can estimate that he has a 98% chance of dying, no saving throw, if he jumps. If you decide that your character jumps, roll percentage dice. A result of 99 or 00 will mean that your character lives, but any other result will mean that he will die in the attempt. Do you still want to jump?"
The chance of rolling 6 damage on 6d6 is 1 in 6^6, which is far less than 1 in 50. So this does seem to be a case of using the fiction as a consideration to override the default mechanics.
But I think the case of invisible elves is different again, and on that one I incline more to your approach. I haven't thought through the "impossible avoidance" scenarios that have been posted, but an invisible elf dodging a dragon's breath doesn't seem any more far-fetched on its face than the fighter chained to the rock doing the same thing.