Most schizophrenia patients do not inhibit their P50 auditory evoked potential to the second of duplicate auditory stimuli, reflecting a failure to inhibit responses to irrelevant sensory input. Typical antipsychotic drugs do not improve this deficit while some atypical antipsychotics do. A previous study using an animal model, deficient P20-N40 (which corresponds to the human P50) inhibitory processing in DBA/2 mice found that sensory inhibition was improved by clozapine, the prototypical atypical antipsychotic, but not by haloperidol, a typical antipsychotic. The improvement after clozapine was mediated by alpha7 nicotinic receptors. The present study addresses whether another atypical antipsychotic, olanzapine, will also improve sensory inhibition deficits in the mouse model. In vivo electrophysiological recordings of the P20-N40 auditory evoked potential in anesthetized DBA/2 mice, which spontaneously exhibit a schizophrenia-like inhibitory processing deficit, were obtained after olanzapine alone (0.01, 0.033, 0.1, 0.33 mg/kg, IP) and the efficacious dose of olanzapine (0.033 mg/kg, IP) in combination with either the alpha7 nicotinic receptor antagonist alpha-bungarotoxin or the alpha4beta2 nicotinic receptor antagonist di-hydro-beta-erythroidine. All doses of olanzapine produced improved P20-N40 inhibitory processing in DBA/2 mice. The normalization observed after the 0.033 mg/kg dose of olanzapine was due to a selective decrease in response to the second auditory stimulus indicating an increase in inhibitory processing. This improvement was blocked by pre-administration of alpha-bungarotoxin but not di-hydro-beta-erythroidine. Like clozapine, olanzapine acts via alpha7 nicotinic receptors to elicit improved inhibitory processing of auditory stimuli.