I don’t think Dorothy was dress untzniusdig at all. From the perspective of frum Jews, you are right, it would not be acceptable today (short sleeves), but I don’t really think that one can look at Dorothy and honestly think anything negative about her clothing. Her entire demeanor is tzniusdig. Modesty is about more than just an inch or two of material.
And I think the fantasy of the story is great escape for children. Learning about the meaning of real friendship, and what values are important in life, and how to be makir tov to one’s family and friends, is a VERY valuable lesson. As a child, I eagerly looked forward to the annual telecast.