JRR Tolkien has Opinions About Things. 
In “On Fairy Stories” he spends some time on taxonomy, establishing categories and assigning characteristics to define membership in each category. He arrives at the opinion that the goal of fairy stories is to achieve Fantasy, by which he means a willingness to accept things contrary to our real world, through sub-creation, by which he means constructing a second world in which Fantasy can be demonstrated. He uses the name Faerie in a general sense when discussing these sub-created second worlds, as well as in a specific sense meaning “where the fairies live”.
It is his opinion that dramatic and other visual forms are hostile to fantasy, because you can see through the fantasy elements, quite literally. In purely literary forms (words only, no visual performance or presence) this is not a problem. He reveals a revulsion for technology as well. I doubt he would consider 1939 film “The Wizard of Oz” a fairy story at all. 
In particular, given his opinion that “Men dressed up as talking animals may achieve buffoonery or mimicry, but they do not achieve Fantasy” suggests that he would be particularly offended by the Cowardly Lion.
However, nothing stops us from setting aside his prejudice against fantastic elements in dramatic forms or against certain electric technologies, from assessing the film by the rubric he sets out in his essay.
To begin, he divorces fairy stories from the idea of children’s literature, ascribing their marriage to a sentimental belief that children are somehow alien and not diminutive and immature members of humanity, and ties this to the idea of fairies as diminutive – an idea he also rejects. This notion of diminutiveness being relevant to children and children being effectively diminutive adults reminds me of the many medieval paintings in which children are depicted as tiny adults. It reminds me of the Munchkins, who are diminutive adults. It reminds me of Dorothy, who, played by Judy Garland at age 17, is an adult dressed to look child-like.
He claims that “It is perhaps not unnatural that in England, the land where the love of the delicate and fine has often reappeared in art, fancy should in this matter turn towards the dainty and diminutive, as in France it went to court and put on powder and diamonds.” 
To extend his comparison, consider the very American way the Munchkins in the film and thank Dorothy: by guild.
He rejects the idea that fairies are supernatural, claiming that they are MORE natural than humans. Once again, I remember the Munchkins, hiding among the flowers until Glinda gives the all-clear.
He says that “… fairy-stories are not in normal English usage stories about fairies or elves, but stories about Fairy, that is Faerie, the realm or state in which fairies have their being.” If the Munchkins are effectively fairies, diminutive, superlatively natural beings, then Oz can be considered a manifestation of Faerie for these purposes, and so perhaps this film is a fairy tale after all.
According to Tolkien, “An essential power of Faerie is thus the power of making immediately effective by the will the visions of ‘fantasy.’ Not all are beautiful or even wholesome, not at any rate the fantasies of fallen Man. And he has stained the elves who have this power (in verity or fable) with his own stain.” The implication is that builders of worlds in fantasy stories spread the stain of the Fall into Faerie. That is, fantasy is a form of fairy story in which the author builds a new realm and imposes on it the concerns of mortal life. This is exactly what I am claiming that dream visions do – they reflect the concerns of daily life.
Here is Tolkien’s eventual, grudging definition of a fairy story:
For the moment I will say only this: a “fairy-story” is one which touches on or uses Faerie, whatever its own main purpose may be: satire, adventure, morality, fantasy. Faerie itself may perhaps most nearly be translated by Magic—but it is magic of a peculiar mood and power, at the furthest pole from the vulgar devices of the laborious, scientific, magician. There is one proviso : if there is any satire present in the tale, one thing must not be made fun of, the magic itself. That must in that story be taken seriously, neither laughed at nor explained away.
Dorothy doesn’t talk about being in a dream while she’s in Oz. A possible structural reason is that doing so would explain away the magic. Now I’m thinking of Peter Pan (which Tolkien must have been aware of, probably disliking the stage production and approving of the novel – the period’s equivalent of saying “the book is better than the movie”) one of whose most abstract themes seems to be about enabling children to believe in magic, and whose own denial of the dream frame allows adult readers to wink and understand while allowing their children to believe in fairies.
For Dorothy, falling asleep in the poppy fields helps to subordinate the dream frame. 
“While Dorothy is adventuring in Oz, she believes she is in Oz. “Toto, I’ve a feeling we’re not in Kansas anymore” suggests that she believes she has traveled; if she believed she had fallen asleep in Kansas, should would not say she wasn’t IN Kansas. She does not talk about dreaming until she is back in Kansas.
Tolkien talks about the eventual defining characteristic of fairy tales as “eucatastrophe” or a vision of joy, which admits the possibility of tragedy and then deliverance. In Oz, I guess this would be the melting of the Wicked Witch. Especially in the film, Dorothy has seen, both literally in the hourglass and figuratively in the sense of peril and desperation she feels while imprisoned, the possibility of tragedy. Her cohort face their own insecurities to free her, but ultimately, it is Dorothy herself who saves Dorothy.
“On Fairy Stories” contains more than a hint of the attitude Tolkien shared with CS Lewis (in “Preface to Paradise Lost”) and Coomaraswamy (in “The Nature of Medieval Art”) that in order to say anything useful about an artifact, you must first know what it is and what it is for. For Dorothy, deliverance by her own hand yields the glimpse of joy Tolkien argues defines a fairy story, and that joy depends on self-knowledge. Knowing who you are is a necessary part of knowing what you are good for, of knowing where you fit into society, of knowing your home – like which there is no place.
Racicot, Dreaming 