The line is between species that are PC-playable and species that are not. If a species is PC-playable then it naturally follows that any member of that species has the potential to become a PC; and because any member of that species has that potential they all need to be "designed" the same in the setting, without regard to whether that potential is ever followed through on or not.
Again, just your expectation. But how about an elf that has been infected by a Mind Flayer ? Or corrupted by a demon ? Or even one that was very unusual, form across the world, and how had access to training or powers that the PCs did not ? Why am I obliged to give these powers that relate to what the PCs can do ?
One night is no problem. But we do multi-year campaigns, and this was to be one (and became one, though half of us left not long in).
I hope that you see my point, if a DM's style is not up to your expectations, you can always walk ou,t after clarifications if possible. Not much harm done, and if a DM's style is not what you are looking for, you can usually see pretty fast...
That girlfriend example you gave - I'd walk out on that game right quick (or, far more likely, get voted out; as it'd be a her-or-me choice). Even if done well, as it seems to have been here, it's still non-negotiably unacceptable in my eyes.
And we had a long extremely enjoyable campaign that left many fine memories, so you would have deprived yourself of that for what exactly ? Again, it's fine to have different playstyles, but sometimes your choices also make you miss opportunities...
I'm not denying the DM was the victim. What I'm saying is that players are always going to push the envelope even just that little bit and if the DM can't or won't push back then DMing probably isn't their thing.
And some players will be mature enough to allow the DM's confidence to grow as well. Personality is one thing, potential another. Stress is both a terrible and a wondrous thing, for example. At the right amount, it's a motivator, but too much and it brings you down. The guy might have turned out just fine with other players, more time, different circumstances.
Nothing wrong with any of that provided the PC Elves have the potential to do it too. The thing is, if those potentials exist then for game-based reasons they need to be written into the racial write-up for Elves so players know what their options are.
And again, why should the players have access to all the options ? It's not the case in all books/novels of the genre for example. Although it's a really bad example, look at "the Crystal Shard", no PC has an instant path to power like the wizard had when finding the relic...
Same with real-world people - we don't all end up with karate power but we pretty much all have the potential for it.
And then again, I don't believe that. We can all become somewhat competent in karate, but few people have the drive and the inborn physical characteristics combined to transform in to a karate champion.
There's a few problems with the design-on-the-fly method in a game context:
--- if something character-based is designed two years into the campaign to suit a player's concept, other players would have a fully valid complaint that this same option wasn't available sooner, when they rolled up their characters. Having all the options in place before the campaign begins takes care of this.
DId they have fun with their character so far ? Yes, so why are they complaining ? Ah yes, jealousy, due to competition between players and power gaps between options...
In any case, we never have any problem at our tables, we allow almost any retrofit as long as it is not a core concept of the character (something that he used all the time) and does not contradict the story so far.
--- when designing on the fly, rather than all at once ahead of time, it's far more difficult to avoid conflicts - every new thing has to be vetted to ensure it meshes with what's already in place.
And that takes hours of game time for situations that might actually never occur. On the other hand, I can guarantee that you will miss 90% of edge cases which will actually occur.
--- changing things on the fly risks invalidating play from before the change was made, or making something that was once possible in the setting impossible. I personally detest this sort of thing; if a DM wants to make big changes like this she should start a new campaign in a new setting where things work differently. (I'm in this boat right now: I've some rather sweeping rule changes I'd like to make - or try out - in my game but to do so I'd need to start a new campaign/setting; yet my current campaign has years of potential left in it which I don't want to waste)
Where's the problem, create a sweeping change on the campaign setting that explains the changes. The FR do this all the time, as long as you don't do it too often, it should not be a problem...