Option number four. Labour would be pointless - if they were doing someone economically useful, they would be taking jobs away from well-paid union workers (hah, if there still were such people!). As for doing senseless work, like digging and filling holes or other Sisyphus-like punishment, I don't see how anything is gained by that.
I'd say the best thing would just be to drug them up like mental patients.
Well, one thing they could do is grow their own food, like they used to in the past. That wouldn't cost too many jobs. Back in the day prisons used to actually make a profit.
Also, it must be considered that we'll save on prison costs that way, so there will be less taxes, so it will be easier to regenerate whatever jobs are lost.