I don't buy that giving somebody a simulation of incarceration is as much of a deterrent as real prison. Besides the fact that real prison causes you to miss years of your life and has a huge physical toll, aren't most prisoners aware that it's not real?
O'Brien didn't know how Agrathi punish people, so when he accidentally kills his cellmate after falsely accusing him of hiding food, it has a tremendous psychological effect. If you knew it was fake, you'd probably be like 'Oh, NO did I kill my fake cellmate? How terribly awful of me I feel SO bad!'
And sociopaths wouldn't even feel bad about killing their cellmate, they'd come out thinking 'HA I get to go back to my regular life, some punishment.' Then they'd start committing crimes with total abandon thinking, worst case scenario, I get another fake prison experience and go right back to my life AGAIN.
And why don't they use this technology for people with terminal illnesses or very old people nearing death? Hey I have cancer, oh darn it, guess I'll have to spend 50 years in a paradise simulation.