Continuity mistake: When they first meet the Tin Man a purple bird with a red beak appears and disappears several times near the house behind them. (00:41:20 - 00:42:20)
Continuity mistake: After both Dorothy and Scarecrow have oiled Tin Man's elbows, Dorothy pulls the Tin Man's arm down and we see her throw the apple that she's holding down behind him. In the next shot it reappears in her left hand. (00:41:55)
Continuity mistake: After they first meet him when Dorothy pulls the Tin Man's arm down we see her dress and there's nothing on it. In the next shot there are several wet spots on the front of it. (00:41:55)
Continuity mistake: In the section just after the Tin Man has been oiled, he drops his axe and starts dancing on the road. After the Witch throws the fire at the Scarecrow, the three of them start down the road to Oz, he has mysteriously picked up his axe. (00:42:45 - 00:47:30)
Continuity mistake: When they first meet the Tin Man, the Scarecrow is holding an apple in each hand. He drops the one in his right hand but the other one disappears when he reaches for the oil can. Later when they all walk away both apples, and the one that Dorothy dropped before, are gone. (00:44:05)
Continuity mistake: After the Tin Man's dance, Dorothy and the Scarecrow shuffle over to a tree trunk where the Tin Man then sits. During this, the oil can in Dorothy's basket clearly falls out, but in the very next shot it is back in the basket. (00:45:25)
Continuity mistake: Dorothy sloppily puts some oil in the shoulder joint and in front of the elbow of the Tin Man after he does his song and dance "If I only had a heart". In the next shot it's gone. (00:45:30)
Continuity mistake: In a close-up of the Tin Man as Dorothy says, "We were just wondering why," there is no oil on his shoulder joint. In the next shot his shoulder joint is wet. (00:45:40)
Continuity mistake: We see the top of the house before the Wicked Witch appears and the right half and chimney are dark. After she appears the lighting has changed and the top of the house is all lit up. (00:45:55)
Continuity mistake: The large pile of wood next to the house is entirely rearranged throughout the scene when the Wicked Witch throws fire down at them. (00:45:55 - 00:47:30)
Continuity mistake: Dorothy is standing against a tree stump when the Wicked Witch throws the fire down at them. In the next shot she's nowhere near the stump. (00:46:20)
Continuity mistake: Dorothy's basket has been moved without anyone going near it after the Wicked Witch leaves the roof top. (00:46:20 - 00:47:30)
Continuity mistake: When the Wicked Witch scares the Scarecrow, Dorothy, and the Tin Man with fire, after the fire is thrown, not only is the Tin Man's funnel cap on backwards, everything is reversed. In order to keep the characters oriented from left to right correctly, they had to show the film from the wrong side, thus the buttons of the Scarecrow's jacket and everything else are on the wrong side. (00:46:40)
Continuity mistake: After the Witch throws a fireball at the Scarecrow in the woods and disappears, Dorothy is holding Toto. But when it cuts to a closeup of her, it looks like her shoulders are extended. When it cuts back to the wide shot, she indeed has her arms around the Scarecrow and Tin Man, even though she never put Toto down. (00:46:55)
Continuity mistake: After the Wicked Witch leaves, the burn spot on the ground where she throws the fire from the roof, disappears. (00:47:25)
Continuity mistake: As they enter the scene with the Cowardly Lion, the Scarecrow falls and then jumps over a patch of weeds growing in the middle of the Yellow Brick Road. In the next shot he does the exact same thing only about three feet behind the patch of weeds that he jumped over before. (00:48:00)
Continuity mistake: In the first shot of them entering the forest before meeting the Cowardly Lion, Toto is nowhere to be seen. In the next shot he appears walking with them. He disappears again later when we first meet the lion. (00:48:00 - 00:49:10)
Continuity mistake: Before they meet the Cowardly Lion, Dorothy starts to say "Lions and Tigers and Bears" and the axe jumps from the Tin Man's left hand to his right between shots. (00:48:20)
Continuity mistake: While Dorothy, Tin Man, and Scarecrow are walking in the dark and creepy forest, just as Dorothy begins to sing "Lions and Tigers and Bears" in the medium shot, Tin Man is holding up the axe in his left hand. But it cuts to the long shot, and the axe is in Tin Man's right hand between shots. (00:48:40)
Continuity mistake: At the start of the "lions and tigers and bears, oh my" sequence, Dorothy, the Scarecrow and Tin Man are all standing separately, then the shot cuts and they're suddenly arm in arm. (00:48:45)
Answer: In the film it's left ambiguous. At the end it's strongly implied that she was dreaming. The characters she meets all look like people she actually knows. In the original book, she actually went to Oz.