The collision induced effects in the third-order Raman response of liquid xenon have been studied both experimentally and theoretically. The effect of electron cloud overlap on the polarizability of xenon dimers was studied using accurate time-dependent density functional theory calculations. The dimer polarizabilities were used to fit parameters in a direct reaction field model that can be generalized to condensed phase systems. This model was employed in molecular dynamics simulations in order to calculate the impulsive Raman response of liquid xenon. Excellent agreement is found between the shape of the calculated and the measured anisotropic part of the response. The shape of this response is little affected by the electron overlap effects, but the intensity is strongly influenced by it. The shape of the isotropic response is predicted to be strongly dependent on electron overlap effects.