For such an unusual and apparently cruel joke, one must conclude that there is no joke intended at all, and that Sancho's flogging satisfies certain conditions of his squire's life.
Religious penitents flog themselves in order to purify their souls by humiliating their bodies and thus to gain grace and heavenly reward after death. Sancho, squire to a knight-errant imbued with a slightly more profane mission, but nonetheless holy, must flog himself in order to deserve serving Dulcinea. Only through faith in this ideal can Sancho gain immortality.
Don Quixote, who has already done his penance, is already in his mistress' service and cheerfully endures suffering for her sake. But not so Sancho, and although his "Dulcinea" is his island, he must nonetheless do penance to gain his reward. The duke even threatens the squire by telling him, "No flogging, no government," and at this final straw, Sancho gives in. In other words, Sancho must now serve Dulcinea. Since he has created her enchantment, he has, in a sense, created Dulcinea, although in a way quite opposite to the way that Don Quixote has created her. Sancho must now, through his past mistakes, commit himself entirely to the quixotic ideal.
